** **

**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSIONWASHINGTON, DC 20549**

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**FORM 10-Q**

**Mark One**

**x****Quarterly Report Pursuant to Section 13 or 15(d) of the SecuritiesExchange Act of 1934 for the Quarterly Period Ended June 30, 2006.**

**or**

**o****Transition Report Pursuant to Section 13 or 15(d) of the SecuritiesExchange Act of 1934 for the Transition Period From            To              .**

Commission filenumber:  **000-25755**

**WORLDGATECOMMUNICATIONS, INC.**(Exact Name of Registrant as Specified in Its Charter)

| **Delaware**              | ** ** | **23-2866697**                        |
|---------------------------|------------|---------------------------------------|
| (State of  Incorporation) |       | (I.R.S. Employer  Identification No.) |

 

**3190Tremont AvenueTrevose, Pennsylvania 19053**(Address of Principal Executive Offices)     (Zip Code)

**(215)354-5100**(Registrant’s Telephone Number, Including Area Code)

Indicate by check markwhether the registrant: (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days.Yes x No o

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer , ora non-accelerated filer.  See definitionof “accelerated filer and large accelerated filer” in Rule 12b-2 of theExchange Act.Large accelerated filer o         Accelerated filer x          Non-accelerated filer o

Indicate by a check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).Yes o No x

As of August 4, 2006,there were 39,898,110 shares of common stock, par value $.01 per share,outstanding.

 

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**WORLDGATECOMMUNICATIONS, INC.**

**QUARTERLYREPORT ON FORM 10-QFOR THE THREE MONTHS ENDED JUNE 30, 2006**

**TABLE OF CONTENTS**
| **PART I. FINANCIAL INFORMATION** |   |                                                                                         |
|-----------------------------------|--------|----------------------------------------------------------------------------------------------|
|                              |   |                                                                                         |   |   |
| Item 1.                           |   | Financial Statements                                                                         |   | 3 |
| Item 2.                           |   | Management’s  Discussion And Analysis Of Financial Condition And Results Of Operations. |   | 20 |
| Item 3.                           |   | Quantitative  And Qualitative Disclosures About Market Risk.                                 |   | 25 |
| Item 4.                           |   | Controls And  Procedures.                                                                    |   | 25 |
|                              |   |                                                                                         |   |   |
| **PART  II. OTHER INFORMATION**   |   |                                                                                         |
|                              |   |                                                                                         |   |   |
| Item 1.                           |   | Legal Proceedings.                                                                           |   | 26 |
| Item  1A.                         |   | Risk  Factors                                                                                |   | 26 |
| Item 2.                           |   | Unregistered  Sales Of Equity Securities And Use Of Proceeds.                                |   | 26 |
| Item 3.                           |   | Defaults Upon  Senior Securities.                                                            |   | 26 |
| Item 4.                           |   | Submission Of  Matters To A Vote Of Security Holders.                                        |   | 26 |
| Item 5.                           |   | Other Information.                                                                           |   | 26 |
| Item  6.                          |   | Exhibits.                                                                                    |   | 26 |

 

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**PART I.FINANCIAL INFORMATION**

ITEM 1.  FINANCIAL STATEMENTS

**WORLDGATE COMMUNICATIONS, INC.CONDENSED CONSOLIDATED BALANCE SHEETS(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)**
| ** **                                                                                                                                                                                 | ** ** | **June 30,**     | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                 | ** ** | **2006  (Unaudited)** | ** ** | **2005  (Audited)**   | ** ** |
| ASSETS                                                                                                                                                                                     |       |                  |       |                  |       |
| Current assets:                                                                                                                                                                            |       |                  |       |                  |       |
| Cash and cash equivalents                                                                                                                                                                  |       | $                     | 7,232      |                  | $          | 16,277 |   |
| Trade accounts receivables                                                                                                                                                                 |       | 845                   |       | 133                   |       |
| Other receivables                                                                                                                                                                          |       | 35                    |       | 26                    |       |
| Inventory, net                                                                                                                                                                             |       | 1,958                 |       | 2,878                 |       |
| Prepaid and other assets                                                                                                                                                                   |       | 400                   |       | 209                   |       |
| Total current assets                                                                                                                                                                       |       | 10,470                |       | 19,523                |       |
| Property and  equipment                                                                                                                                                                    |       | 4,334                 |       | 4,084                 |       |
| Less: accumulated depreciation and amortization                                                                                                                                            |       | (2,871                | )          | (2,508                | )          |
| Property and equipment, net                                                                                                                                                                |       | 1,463                 |       | 1,576                 |       |
| Deposits and  other assets                                                                                                                                                                 |       | 130                   |       | 130                   |       |
| Total assets                                                                                                                                                                               |       | $                     | 12,063     |                  | $          | 21,229 |   |
|                                                                                                                                                                                       |       |                  |       |                  |       |
| LIABILITIES AND  STOCKHOLDERS’ DEFICIENCY                                                                                                                                             |       |                  |       |                  |       |
| Current liabilities:                                                                                                                                                                       |       |                  |       |                  |       |
| Accounts payable                                                                                                                                                                           |       | $                     | 1,321      |                  | $          | 1,695 |   |
| Accrued expenses                                                                                                                                                                           |       | 1,608                 |       | 1,333                 |       |
| Accrued compensation and benefits                                                                                                                                                          |       | 296                   |       | 36                    |       |
| Dividend payable on preferred stock                                                                                                                                                        |       | 2                     |       | 6                     |       |
| Detachable Warrants                                                                                                                                                                        |       | 1,358                 |       | 1,038                 |       |
| Conversion option on preferred stock                                                                                                                                                       |       | 38                    |       | 57                    |       |
| Incentive sales claims liability                                                                                                                                                           |       | 101                   |       | 278                   |       |
| Warranty reserve                                                                                                                                                                           |       | 89                    |       | 336                   |       |
| Deferred revenues                                                                                                                                                                          |       | 218                   |       | 44                    |       |
| Returns reserve                                                                                                                                                                            |       | 0                     |       | 2,310                 |       |
| Total current liabilities                                                                                                                                                                  |       | 5,031                 |       | 7,133                 |       |
| Commitments                                                                                                                                                                                |       |                  |       |                  |       |
| Redeemable  preferred stock; 7,550 shares authorized; 166 shares issued and outstanding  at June 30, 2006, and 500 shares issued and outstanding at December 31, 2005                      |       | 148                   |       | 379                   |       |
|                                                                                                                                                                                       |       |                  |       |                  |       |
| Stockholders’  deficiency:                                                                                                                                                            |       |                  |       |                  |       |
| Preferred Stock,  $.01 par value, 13,492,450 shares authorized; 0 shares issued at June 30,  2006 and December 31, 2005.                                                                   |       | 0                     |       | 0                     |       |
| Common Stock,  $.01 par value; 80,000,000 shares authorized; 39,762,111 shares issued and  outstanding at June 30, 2006 and 39,511,519 shares issued and outstanding at  December 31, 2005 |       | 398                   |       | 395                   |       |
| Additional paid-in  capital                                                                                                                                                                |       | 245,013               |       | 242,414               |       |
| Deferred stock  based compensation                                                                                                                                                         |       | (1,600                | )          | 0                     |       |
| Accumulated  deficit                                                                                                                                                                       |       | (236,927              | )          | (229,092              | )          |
|                                                                                                                                                                                       |       |                  |       |                  |       |
| Total stockholders’ deficiency                                                                                                                                                        |       | 6,884                 |       | 13,717                |       |
|                                                                                                                                                                                       |       |                  |       |                  |       |
| Total liabilities and stockholders’ deficiency                                                                                                                                        |       | $                     | 12,063     |                  | $          | 21,229 |   |
|                                                                                                                                                                                       |       |                  |       |                  |       |

 

The accompanying notes are an integral part of these condensedconsolidated financial statements.

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**WORLDGATE COMMUNICATIONS, INC.CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS(Unaudited)(Dollars in Thousands, Except per Share Amounts)**
| ** **                                                                                                                                                                                                                                        | ** ** | **Three Months ended June 30,** | ** ** | **Six Months ended June 30,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                                                                                                                                                                                        | ** ** | **2006**                                            | ** ** | **2005**                                          | ** ** | **2006** | ** ** | **2005** | ** ** |
| Revenues                                                                                                                                                                                                                                          |       | $                                                   | 186        |                                              | $          | 1,399 |   | $ | 696 |   | $ | 1,577 |   |
| Cost of revenues                                                                                                                                                                                                                                  |       | 739                                                 |       | 1,266                                             |       | 1,181 |   | 1,390 |   |
| Gross margins                                                                                                                                                                                                                                     |       | (553                                                | )          | 133                                               |       | (485 | ) | 187 |   |
| Engineering and  development (excluding depreciation and amortization amounts of $93 and $73  for the three months ended June 30, 2006 and 2005, respectively, and $181 and  $139 for the six months ended June 30, 2006 and 2005, respectively). |       | 1,540                                               |       | 1,243                                             |       | 2,994 |   | 2,462 |   |
| Sales and  marketing (excluding depreciation and amortization amounts of $15 and $10 for  the three months ended June 30, 2006 and 2005, respectively, and $29 and $18  for the six months ended June 30, 2006 and 2005, respectively).           |       | 548                                                 |       | 640                                               |       | 1,201 |   | 1,018 |   |
| General and  administrative (excluding depreciation and amortization amounts of $76 and  $88 for the three months ended June 30, 2006 and 2005, respectively, and $153  and $185 for the six months ended June 30, 2006 and 2005, respectively).  |       | 1,846                                               |       | 1,017                                             |       | 4,369 |   | 1,951 |   |
| Depreciation and  amortization                                                                                                                                                                                                                    |       | 184                                                 |       | 171                                               |       | 363 |   | 342 |   |
| Total expenses  from operations                                                                                                                                                                                                                   |       | 4,118                                               |       | 3,071                                             |       | 8,927 |   | 5,773 |   |
| Loss from operating  activities                                                                                                                                                                                                                   |       | (4,671                                              | )          | (2,938                                            | )          | (9,412 | ) | (5,586 | ) |
| Interest and  other income                                                                                                                                                                                                                        |       | 100                                                 |       | 109                                               |       | 233 |   | 175 |   |
| Change in fair  value of warrants and conversion options                                                                                                                                                                                          |       | (520                                                | )          | 2,466                                             |       | (339 | ) | 7,642 |   |
| Gain on contract  termination                                                                                                                                                                                                                     |       | 0                                                   |       | 0                                                 |       | 1,792 |   | 0 |   |
| Interest and other  expense                                                                                                                                                                                                                       |       | 0                                                   |       | (3                                                | )          | 0 |   | (3 | ) |
| Net (loss)  income                                                                                                                                                                                                                                |       | (5,091                                              | )          | (366                                              | )          | (7,726 | ) | 2,228 |   |
| Accretion on  preferred stock, dividends and deemed dividends                                                                                                                                                                                     |       | (40                                                 | )          | (139                                              | )          | (108 | ) | (635 | ) |
| Net (loss)  income available to common stockholders                                                                                                                                                                                               |       | $                                                   | (5,131     | )                                                 | $          | (505 | ) | $ | (7,834 | ) | $ | 1,593 |   |
| Net (loss) income per  common share:                                                                                                                                                                                                              |       |                                                |       |                                              |       |   |   |   |   |
| Basic                                                                                                                                                                                                                                             |       | $                                                   | (0.13      | )                                                 | $          | (0.01 | ) | $ | (0.20 | ) | $ | 0.07 |   |
| Fully Diluted                                                                                                                                                                                                                                     |       | $                                                   | (0.13      | )                                                 | $          | (0.01 | ) | $ | (0.20 | ) | $ | 0.06 |   |
| Net (loss) income  available to common stockholders per common share:                                                                                                                                                                             |       |                                                |       |                                              |       |   |   |   |   |
| Basic                                                                                                                                                                                                                                             |       | $                                                   | (0.13      | )                                                 | $          | (0.02 | ) | $ | (0.20 | ) | $ | 0.05 |   |
| Fully Diluted                                                                                                                                                                                                                                     |       | $                                                   | (0.13      | )                                                 | $          | (0.02 | ) | $ | (0.20 | ) | $ | 0.04 |   |
| Weighted average common  shares outstanding:                                                                                                                                                                                                      |       |                                                |       |                                              |       |   |   |   |   |
| Basic                                                                                                                                                                                                                                             |       | 39,625,256                                          |       | 33,546,229                                        |       | 39,610,667 |   | 32,569,598 |   |
| Fully Diluted                                                                                                                                                                                                                                     |       | 39,625,256                                          |       | 33,546,229                                        |       | 39,610,667 |   | 36,495,858 |   |

 

The accompanying notes are an integral part of these condensedconsolidated financial statements.

 

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**WORLDGATECOMMUNICATIONS, INC.CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS(Unaudited)(Dollars in Thousands)**
| ** **                                                                            | ** ** | **Six Months ended June 30,** | ** ** |
|---------------------------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                            | ** ** | **2006**                                          | ** ** | **2005** | ** ** |
|                                                                                  |       |                                              |       |   |   |
| Cash flows from  operating activities:                                                |       |                                              |       |   |   |
| Net (loss) income                                                                     |       | $                                                 | (7,726     | ) | $ | 2,228 |   |
| Adjustments to  reconcile net (loss) income to net cash used in operating activities: |       |                                              |       |   |   |
| Depreciation and amortization                                                         |       | 363                                               |       | 342 |   |
| Change in fair value of warrants and conversion  options                              |       | 339                                               |       | (7,642 | ) |
| Gain on contract termination                                                          |       | (1,792                                            | )          | 0 |   |
| Write down of inventory                                                               |       | 490                                               |       | 0 |   |
| Non-cash stock based compensation                                                     |       | 426                                               |       | 0 |   |
| Changes in  operating assets and liabilities:                                         |       |                                              |       |   |   |
| Trade accounts receivable                                                             |       | (712                                              | )          | (1,075 | ) |
| Other receivables                                                                     |       | (9                                                | )          | (12 | ) |
| Inventory                                                                             |       | (646                                              | )          | (958 | ) |
| Prepaid and other assets                                                              |       | (191                                              | )          | 60 |   |
| Accounts payable                                                                      |       | (374                                              | )          | 1,749 |   |
| Accrued expenses                                                                      |       | 604                                               |       | (72 | ) |
| Accrued compensation and benefits                                                     |       | 260                                               |       | (183 | ) |
| Warranty reserve                                                                      |       | (14                                               | )          | 0 |   |
| Deferred revenue                                                                      |       | 174                                               |       | (359 | ) |
| Net cash used in operating activities                                                 |       | (8,808                                            | )          | (5,922 | ) |
|                                                                                  |       |                                              |       |   |   |
| Cash flows from  investing activities:                                                |       |                                              |       |   |   |
| Capital expenditures                                                                  |       | (250                                              | )          | (322 | ) |
| Net cash used in investing activities                                                 |       | (250                                              | )          | (322 | ) |
|                                                                                  |       |                                              |       |   |   |
| Cash flows from  financing activities:                                                |       |                                              |       |   |   |
| Payment of note payable                                                               |       | 0                                                 |       | (37 | ) |
| Proceeds from issuance of common stock                                                |       | 13                                                |       | 21 |   |
| Proceeds from the exercise of stock options                                           |       | 0                                                 |       | 465 |   |
| Proceeds from the exercise of stock rights and  warrants                              |       | 0                                                 |       | 1,475 |   |
| Net cash provided by financing activities                                             |       | 13                                                |       | 1,924 |   |
| **Net  decrease in cash and cash equivalents**                                        |       | (9,045                                            | )          | (4,320 | ) |
| **Cash  and cash equivalents, beginning of period**                                   |       | 16,277                                            |       | 11,840 |   |
| **Cash  and cash equivalents, end of period**                                         |       | $                                                 | 7,232      |   | $ | 7,520 |   |
|                                                                                  |       |                                                   |       |  |   |
|                                                                                  |       |                                              |       |   |   |
| Cash paid for interest                                                                |       | $                                                 | 0          |   | $ | 1 |   |
| Non-cash  financing activities:                                                       |       |                                              |       |   |   |
| Conversion of preferred  stock to common stock                                        |       | $                                                 | 333        |   | $ | 4,350 |   |
| Accretion on preferred  stock                                                         |       | 34                                                |       | 522 |   |
| Dividends payable on  preferred stock                                                 |       | 2                                                 |       | 30 |   |
| Deemed dividend on  conversion of preferred stock                                     |       | 68                                                |       | 0 |   |
| Common stock issued for  accrued dividends                                            |       | 4                                                 |       | 168 |   |
| Issuance of note payable to finance D&O insurance                                 |       | 0                                                 |       | 230 |   |

 

The accompanying notes are an integral part of these condensedconsolidated financial statements.

 

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**WORLDGATECOMMUNICATIONS, INC.NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**(DollarAmounts are in Thousands, Except for per Share Amounts)(Unaudited)**

1.                          Basis of Presentation.

    The unaudited condensed consolidatedfinancial statements of WorldGate Communications, Inc. (“WorldGate” or the “Company”)for the three and six months ended June 30, 2006 and June 30, 2005 presentedherein have been prepared by the Company pursuant to the rules and regulationsof the Securities and Exchange Commission for quarterly reports on Form10-Q.  Certain information and footnotedisclosures normally included in financial statements prepared in accord­ancewith United States generally accepted accounting principles have been condensedor omitted pursuant to such rules and regulations.  These financial statements should be read inconjunction with the financial statements for the year ended December 31, 2005and the notes thereto included in the Company’s Annual Report on Form 10-K.

    The financial information in this Reportreflects, in the opinion of management, all adjustments of a normal recurringnature necessary to present fairly the results for the interim period.Quarterly operating results are not necessarily indicative of the results thatmay be expected for the year ending December 31, 2006.

2.                            Reclassification

    Certain reclassifications have been made tothe condensed consolidated financial statements shown for the prior period inorder to have it conform to the current period’s classifications.  The reclassifications have no effect onpreviously reported losses.

3.                            Liquidity and Going Concern Considerations.

As of June 30, 2006the Company had cash and cash equivalents of $7,232.  The operating cashused in continuing operations for the three and six months ended June 30,2006 was $3,210 and $8,808, respectively.

In December 2003 andJanuary 2004, WorldGate received investments aggregating $3,100 fromcertain institutional investors. These investors purchased an aggregate of3,000,000 shares of newly issued common stock. The investors also received aright, for a limited period of time, to purchase additional shares of up to 20%of the common stock purchased by the investors in their investment, at the sameprice as their investment, and five-year warrants to purchase up to 30% of thecommon stock purchased by the investors in their investment, at an exerciseprice equal to a 25% premium to their purchase price for the investment. Thepurchase price for the 2,000,000 shares purchased in the December 2003transactions were $0.80 per share, with the warrants having a $1.00 per shareexercise price. The purchase price for the 1,000,000 shares purchased in theJanuary 2004 transaction was $1.50 per share, with the warrants having a$1.875 per share exercise price. All additional investment rights associatedwith the December 2003 transaction were exercised during January andFebruary of 2004, resulting in an incremental investment of $320. Alladditional investment rights associated with the January 2004 transactionwere exercised in May 2004, resulting in an incremental investment of$300. A portion of the warrants and additional investment right warrantsassociated with the December 2003 and January 2004 transactions wereexercised in December 2004 and January 2005, resulting in an incrementalinvestment of $925.

In December 2003,WorldGate reached agreement with Mototech, Inc. (“Mototech” is not anaffiliate of General Instruments or Motorola) for the purchase of 625,000shares of newly issued common stock at $0.80 per share, in return for futuredesign and engineering services by Mototech. WorldGate had previouslycontracted with Mototech to assist the Company with the design and volumemanufacture of WorldGate’s Ojo personal video phone. The purchase price forthese shares has been fully paid as of December 31, 2004 by an equivalentreduction in the development and initial procurement payments that wouldotherwise be due to Mototech. The value of this transaction was $600 (based onthe closing stock price of $0.96 on the date of the transaction) of which $200was recorded as an expense for the year ended December 31, 2003 and $400 wasexpensed for the year ended December 31, 2004. In addition, in April 2004,Mototech invested $1,000 to purchase 666,666 shares of newly issued commonstock at $1.50 per share.

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In June 2004we completed a private placement of 7,550 shares of Series A Convertiblepreferred stock to certain institutional investors.  The shares were soldfor $1,000 per share, resulting in gross proceeds from the offering of $7,550.The preferred stock issued pursuant to this placement is convertible intoWorldGate common stock at a conversion price of $2.35 per share. WorldGate hasthe right to require conversion of the preferred stock into common stock uponachieving certain price targets with respect to its common stock and thesatisfaction of certain other conditions. Of the 7,550 convertible preferredissued, 500 shares remained outstanding as of December 31, 2005 and 166 sharesremain outstanding as of June 30, 2006. Between November 2004 and June 2006 all but one of theinvestors has fully converted their preferred shares resulting in the issuanceof 3,142,128 of our common shares. The preferred stock has a dividend rate of 5%per annum, payable quarterly, which may be paid either by cash or through theissuance of common stock at WorldGate’s option (with stock payments being madeat a 10% discount to the then current market price). Through June 30, 2006, forall quarterly dividend payments due, WorldGate exercised its right to makethese dividend payments in stock, resulting in the issuance of an additional139,397 shares of our common stock. The preferred stock has a staged maturityover three years with scheduled payments of one third due after 18 months, onehalf of the remainder due after 24 months and the balance due after 36 months.The preferred stock may be redeemed at maturity in cash or through the issuanceof an indeterminate number of shares of common stock, at WorldGate’s option(subject to certain conditions). All dividend and maturity payments made instock are subject to the satisfaction of certain conditions including thelisting and availability of an effective registration statement. As part of thetransaction, WorldGate issued five-year warrants to purchase a total of1,606,380 shares of WorldGate common stock, with one-half of the warrantshaving an exercise price of $2.69 per share and the remaining half having anexercise price of $3.14 per share. Through December 2005, 125,000 of the$2.69 warrants have been exercised resulting in the issuance of an additional125,000 of our common shares and an additional $336 in gross proceeds; 51,915of the $3.14 warrants have been exercised resulting in the issuance of anadditional 51,915 of our common shares and an additional $163 in grossproceeds. The investors also received an additional investment right, for alimited period of time, to purchase 1,606,380 additional common shares at $3.14a share. During December 2004, all but one of the investors exercisedtheir additional investment rights resulting in the issuance of an additional1,500,000 shares and an additional $4,710 in gross proceeds. During the firstquarter of 2005, the remaining investor exercised its additional investmentright resulting in the issuance of an additional 106,383 shares and anadditional $334 in gross proceeds. The private placement includes numerousprovisions intended to protect these institutional investors including a cashpayment penalty of 1.0% per month for unredeemed preferred shares onceregistration of the shares lapse and until the registration again becomeseffective.

In December 2004, WorldGate completed a privateplacement of 208,333 shares of its common stock to K. Y. Chou, President andGeneral Manager of Mototech, at a sales price of $2.40 per share, whichresulted in additional gross proceeds to the Company of $500.  Inconnection with this placement the Company granted warrants to Mr. Chou topurchase up to 62,500 shares of common stock at an exercise price of $2.88 pershare.

In August 2005, the Company completed a privateplacement of $17,500 of its common stock and warrants with severalinstitutional investors. The Company issued 4,666,664 shares of its commonstock at $3.75 per share to the participating investors. The Company alsoissued five-year warrants to purchase a total of 1,671,947 shares of its commonstock: 1,633,333 shares to the investors at an exercise price of $5.00 pershare, and 38,614 shares to the placement agent at an exercise price of $4.53per share. The investors also received an additional investment right, fora period of 60 days from the time the shares become registered, to purchase1,554,000 additional shares of common stock at $4.12 per share. The accountingfor these warrants and investment rights is established by analogy toAccounting Principle Board Opinion (“APB”) No. 14 “Accounting forConvertible Debt and Debt Issued with Stock Purchase Warrants,” which addressesdetachable stock purchase warrants issued in conjunction with convertible debtand prescribes that such warrants be accounted for as additional paid incapital measured at fair value. The private placement includes numerousprovisions intended to protect these institutional investors including a cashpayment penalty of 1.5% per month for the period above 120 days from theeffective date of the agreement that the shares in the transaction fail to beregistered. The Registration Statement covering the shares under this privateplacement was not declared effective until June 1, 2006.  Until such time as the shares were registeredthe Company was subject to the penalty provision under this private placement.For the three months ended June 30, 2006 and 2005 the Company recorded and expensedrelated penalties of $599 and $0, respectively. For the six months ended June 30, 2006 and 2005 the Company recorded andexpensed related penalties of $1,387 and $0, respectively. The related unpaidpenalties accrued as of June 30, 2006 and December 31, 2005 were $630 and $525,respectively.   On July 25, 2006, theCompany amended the terms of the additional investment right that was grantedto an investor as part of the August 2005 private placement, with respect to aportion of shares of common stock purchasable thereunder and agreed to apply$158 of accrued penalties towards the exercise price of such amended additionalinvestment right, for the purchase of 129,950 shares of common stock. Thepenalties had accrued with respect to the Company’s inability to register theshares acquired by such investor in the private placement within 120 days ofthe transaction.  In consideration forthis amendment and application of the exercise proceeds the investor agreed toforego any cash payment of the penalties other than as available through theproceeds of the exercise of the amended investment right and to grant to theCompany a release of all claims relating to the late registration of theprivate placement shares, other than the aforesaid penalties.  The amendedadditional investment right

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provides that theinvestor thereof may purchase the 129,950 shares of common stock for a periodof 760 days beginning June 1, 2006 for an exercise price of $1.515 pershare.  The terms of the additional investment rights with respect to theremaining 1,424,050 shares of common stock purchasable thereunder remainunchanged.  On July 26, 2006 thisinvestor exercised the additional investment right for 129,950 shares.

Registration statements for the securities soldpursuant to the June 2004, December 2004 and August 2005 private placementswere originally filed containing financial statements that were current at thetime of the filing. Subsequently, the Company initiated a process to amend,restate, and re-file certain of its 2003, 2004 and 2005 financial statements tocorrect an error in the accounting treatment for various security components ofour private placements. As a result the registration statements then on filealso needed to be amended to reflect these changes in our financial statements.Amended registration statements were subsequently filed with the SEC to reflectthe amended and restated financial statements, and became effective on June 1,2006.

On April 28,2004, the Company entered into a multi-year agreement with General InstrumentCorporation d/b/a the Connected Home Solutions Business of Motorola, Inc.(“General Instrument”) for the worldwide development and distribution of theOjo personal video phone. This agreement provided for General Instrument to beWorldGate’s exclusive distributor of its broadband video phone products and forWorldGate to be General Instrument’s exclusive supplier of its broadband videophone products.  On February 17, 2006, wemutually agreed with General Instrument to end this agreement.  The ending of this agreement immediatelyterminates exclusivity for both parties. In addition to its current role fordevelopment and manufacture of Ojo, WorldGate will now have directresponsibility and control for the advertising, marketing, and distribution ofits products.   Under its agreement with General Instrument,WorldGate had been active in marketing and promoting its products, and workingwith General Instrument to distribute Ojo. WorldGate continued the rollout ofOjo using many of the same distributors, retailers and service providers, andplans to expand distribution to service providers and retailers around theworld.  The two companies will work together to ensure a smooth transitionfor customer accounts.  As part of endingits agreement with General Instrument, and in anticipation of WorldGateinventory requirements as a result of taking full responsibility for productdistribution, WorldGate negotiated the right to buy back about two-thirds ofthe units sold to General Instrument, valued at approximately $2,765 (basedupon the original sales price to General Instrument), for approximately $1,064.This is less than half of what it would cost the Company to purchase the sameinventory from its manufacturing sources. As a result, the Company recorded a reserve for returns and reducedrevenue in the amount of approximately $2,310 during the fourth quarter of2005. In addition, the Company has recorded no revenue for units shipped toGeneral Instrument in the first quarter 2006 and has recorded a gain ontermination of this agreement of approximately $1,792 during the first quarter2006 as a result of the lower purchase price of the inventory repurchased fromGeneral Instrument ($1,342, net of the cost of rework for rebranding theproduct and the adjustment of the inventory to its current replacement value)and reversal of  the product refundprogram reserve ($212) as well as an adjustment of the warranty reserve forproducts repurchased ($233), both of which resulted from the termination of theCompany’s agreement with General Instrument.

The Company had$5,031 of liabilities and its assets are not pledged as collateral as ofJune 30, 2006. These liabilities include $1,398 of dividends, detachablewarrants and conversion options related to the Company’s private placement ofpreferred stock.

Our Company hassuffered recurring losses from operations and had an accumulated deficit of$236,927 as of June 30, 2006 and these issues raise substantial doubt about theCompany’s ability to continue as a going concern. Our short term cashrequirements and obligations include, inventory, accounts payable and capitalexpenditures from continuing operations, operating expenses, and the redemptionof preferred stock, of which $166 is required to be redeemed in June 2007,although this redemption can be made in common stock if certain conditions aremet.  In addition, the August 2005private placement includes cash payment penalties of 1.5% per month for theperiod that the shares in the transaction fail to be registered. TheRegistration Statement covering the shares under this private placement was notdeclared effective until June 1, 2006. Until such time as the shares wereregistered the Company was subject to the penalty provision under this privateplacement. For the three months ended June 30, 2006 and 2005 the Companyrecorded and expensed related penalties of $599 and $0, respectively.  For the six months ended June 30, 2006 and2005 the Company recorded and expensed related penalties of $1,387 and $0,respectively. The related unpaid penalties accrued as of June 30, 2006 andDecember 31, 2005 was $630 and $525, respectively.

Management expects, basedon our internal forecasts and assumptions including among others, assumptionsregarding our short term cash requirements, our projected revenue growth, andour ability to obtain stockholder approval and an effective registration forour recent August 11, 2006 funding transaction (see Note 14), that we wouldhave sufficient cash on hand to meet its obligations into the second half of2007.

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The Company’s ability togenerate cash is dependent upon the sale of Ojo products and on obtaining cashthrough capital markets. The Company began generating revenue fromcommercial shipment of the Ojo product in April 2005.  Initially all product sales were conductedthrough General Instrument, our exclusive distributor and all revenue was basedupon sales of our products to General Instrument for their distribution toresellers.  In February 2006, ourdistributor relationship with General Instrument was ended and we began todirectly distribute and sell our products. This transition process, including forming direct relationships with theresellers and adding incremental distribution resulted in a delay in ourongoing sales and a decrease in revenue from the first half of 2006 versus2005.   As we complete our transitionactivities we expect revenues to increase as we continue to roll out ourproducts to the marketplace. Depending on the ramp up of sales and theachievable margin, the increased level of sales activity should have a positiveimpact on our cash flows from operations, which will support our ability tomeet our cash requirements in the long term. Given that the video phone businessinvolves the development of a new product line with no market penetration, inan underdeveloped market sector, no assurances can be given that sufficientsales, if any, will materialize.

Additionally, as needed,the Company plans to generate cash by turning to the capital markets forfurther funding.  No assurances can be given that, if pursued, additionalfinancing transactions can be consummated.  The Company  continues to evaluate possibilities to obtainadditional financing through public or private equity or debt offerings, bankdebt financing, asset securitizations, or from other sources, should theCompany need to obtain such financing.  Such additional financing would besubject to the risk of availability, may be dilutive to our stockholders, or couldimpose restrictions on operating activities. There can be no assurance thatthis additional financing will be available on terms acceptable to the Company,if at all.

Long term cash requirement obligations are primarilycomprised of the items noted above. The Company has no long term debt as ofJune 30, 2006.  However, the financingsecured on August 11, 2006 (see Note 14) will add long term debt to the balancesheet.   The Company has limited capacity to reduce its workforce andscale back on capital and operational expenditures to decrease our cash usage.

4.                                       RecentAccounting Pronouncement.

In November 2004, the Financial AccountingStandards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”)No. 151 “Inventory Costs” which amends the guidance in ARB No. 43,Chapter 4 “Inventory Pricing,” to clarify the accounting for abnormal amountsof idle facility expense, freight, handling costs, and wasted material(spoilage). ARB 43 previously stated that under some circumstances, items suchas idle facility expense, excessive spoilage, double freight, and rehandlingcosts may be so abnormal as to require treatment as current period charges.”SFAS No. 151 requires that those items be recognized as current periodcharges regardless of whether they meet the criterion of “so abnormal.” Inaddition, SFAS No. 151 requires that allocation of fixed productionoverheads to the costs of conversion be based on the normal capacity of theproduction facilities. SFAS No. 151 is effective for inventory costsincurred during fiscal years beginning after June 15, 2005. Earlierapplication is permitted for inventory costs incurred during fiscal yearsbeginning after the date SFAS No. 151 was issued. SFAS No. 151 shallbe applied prospectively. The  adoption ofSFAS No. 151 has not  materiallyeffected the Company’s condensed consolidated financial statements.

InDecember 2004, the FASB issued SFAS No. 123 (R), “Share-Based Payment”that focuses primarily on accounting for transactions in which an entity obtainsemployee services in share-based payment transactions. This statement replacesSFAS No. 123, “Accounting for Stock-Based Compensation,” and supersedesAPB Opinion No. 25, “Accounting for Stock Issued to Employees.”  In March 2005, the Securities and ExchangeCommission issued Staff Accounting Bulletin No. 107 (“SAB 107”) relating to theadoption of SFAS 123R.  SAB 107 primarilyinterprets how the implementation of SFAS 123R is to be applied under SEC rulesand regulations. Beginning January 1, 2006, the Company is required toexpense the fair value of employee stock options and similar awards. TheCompany has elected to utilize the modified prospective transitional method inaccounting for share-based employee payment transactions. Based upon the employeeoptions outstanding as of June 30, 2006, and the transitional provisions ofSFAS No.123R and SAB 107, there are approximately $1,600 of future costs,utilizing the fair value method that will be expensed over a four year periodfrom 2006 through 2010.  Additionally,the Company will utilize the fair value method for any future instrumentsissued after January 1, 2006 (for more details, refer to Note 6).

In March 2005, the FASB issued InterpretationNo. 47 (FIN 47) to clarify the guidance included in SFAS No. 143, “Accountingfor Asset Retirement Obligations.”  FIN47 requires companies to recognize a liability for the fair value of a legalobligation to perform asset retirement activities that are conditional on afuture event if the amount can be reasonably estimated.  If amounts cannotbe reasonably estimated, certain disclosures will be required about theunrecognized asset

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retirementobligations.  The adoption of FIN 47 didnot have a material effect on the Company’s condensed consolidated financialposition or results of operations.

In May 2005, SFAS No. 154, “AccountingChanges and Error Corrections — replacement of APB Opinion No. 20 and FASBStatement No. 3,” was issued. SFAS No. 154 changes the accounting forand reporting of a change in accounting principle by requiring retrospectiveapplication to prior periods’ financial statements of changes in accountingprinciple unless impracticable. SFAS No. 154 is effective for accountingchanges made in fiscal years beginning after December 15, 2005. The adoptionof SFAS No. 154 did not have a material impact on the Company’s condensedconsolidated results of operations, financial position or cash flows.

In June 2005, the EITF reached consensus on Issue No.05-2, “The Meaning of  ConventionalConvertible Debt Instrument’ in EITF Issue No. 00-19, ‘Accounting forDerivative Financial Instruments Indexed to, and Potentially Settled in, aCompany’s Own Stock.’” Issue 00-19 is used to evaluate whether embeddedderivatives should be bifurcated under SFAS No. 133, “Accounting For DerivativeInstruments and Hedging Activities,” as amended. Specifically, SFAS No.133provides guidance as to when an issuer is required to bifurcate a conversionoption that is embedded in convertible debt. However, Issue 00-19 does not define“conventional convertible debt instrument.” Given the development of numerouscontractual terms that may be included in a convertible debt instrument, it isnot clear when a convertible debt instrument is “conventional.”  We do not believe that our redeemablepreferred stock and related warrants meet the definition of conventionalconvertible debt and as a result Issue No. 00-19 applies to the liabilitytreatment of these instruments.  Theadoption of the Issue did not have an effect on the Company’s condensedconsolidated financial position or results of operations.

In September 2005, the EITF reached consensus on IssueNo. 04-13, “*Accounting for Purchasesand Sales of Inventory with the Same Counterparty,”*that inventorypurchases and sales transactions with the same counterparty that are enteredinto in contemplation of one another should be combined for purposes ofapplying APB Opinion No. 29, “*Accountingfor Nonmonetary Transactions.”* The effect reduces reported revenues and costof sales for affected transactions. The consensus on this issue applies to suchtransactions beginning in the first quarter 2006.   The adoption of Issue No. 04-13 did not havea material effect on the Company’s condensed consolidated financial position orresults of operations.

In September 2005, the FASB ratified the EITF IssueNo. 05-7, “Accounting for Modifications to Conversion Options Embedded in DebtInstruments and Related Issues,” which addresses whether a modification to aconversion option that changes its fair value effects the recognition ofinterest expense for the associated debt instrument after the modification, andwhether a borrower should recognize a beneficial conversion feature, not a debtextinguishment, if a debt modification increases the intrinsic value of thedebt (for example, the modification reduces the conversion price of the debt).The adoption of the Issue did not have a material effect on our condensedconsolidated financial position or results of operations.

In September 2005, the FASB also ratified the EITF’sIssue No. 05-8, “Income Tax Consequences of Issuing Convertible Debt with aBeneficial Conversion Feature,” which discusses whether the issuance ofconvertible debt with a beneficial conversion feature results in a basisdifference arising from the intrinsic value of the beneficial conversionfeature on the commitment date (which is recorded in the stockholder’s equity for book purposes, but as aliability for income tax purposes) and, if so, whether that basis difference isa temporary difference under SFAS No. 109, “Accounting for Income Taxes.”  The adoption of the Issue did not have amaterial effect on the Company’s condensed consolidated financial position orresults of operations.

                InFebruary 2006, the FASB issued SFAS No. 155 ‘‘Accounting for Certain HybridFinancial Instruments, an amendment of FASB Statements No. 133 and 140’’ (‘‘SFAS155’’). SFAS 155 clarifies certain issues relating to embedded derivatives andbeneficial interests in securitized financial assets. The provisions of SFAS155 are effective for all financial instruments acquired or issued after fiscalyears beginning after September 15, 2006. The Company is currently assessingthe impact that the adoption of SFAS 155 will have on its results of condensedconsolidated operations and financial position.

InMarch 2006, the FASB issued SFAS No. 156, “Accounting for Servicingof Financial Assets” (“SFAS 156”), which amends SFAS 140, “Accountingfor Transfers and Servicing of Financial Assets and Extinguishments of Liabilities,”with respect to the accounting for separately recognized servicing assets andservicing liabilities. SFAS 156 permits the choice of theamortization method or the fair value measurement method, with changes in fairvalue recorded in income, for the subsequent measurement for each class ofseparately recognized servicing assets and servicing liabilities. The statementis effective for years beginning after September 15, 2006, with earlieradoption permitted. The Company is currently evaluating the effect thatadopting this statement will have on the Company’s financialposition and results of operations.

In June 2006, theFASB issued Interpretation No. 48, “Accounting for Uncertainty in IncomeTaxes” (FIN 48). This interpretation clarified the accounting for uncertaintyin income taxes recognized in accordance with FASB Statement No. 109,

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“Accounting for IncomeTaxes” (SFAS No. 109). Specifically, FIN 48 clarifies the application ofSFAS No. 109 by defining a criterion that an individual tax position mustmeet for any part of the benefit of that position to be recognized in anenterprise’s financial statements. Additionally, FIN 48 provides guidance onmeasurement, derecognition, classification, interest and penalties, accountingin interim periods of income taxes, as well as the required disclosure andtransition. This interpretation is effective for fiscal years beginning afterDecember 15, 2006. The Company is currently evaluating the requirements ofFIN 48 and does not expect that the adoption of FIN 48 will have a significantimpact on the Company’s condensed consolidated financial position andresults of operations.

5.           Inventories.

The Company’sinventory as carried in its financial statements is all finished goodsinventory.  The Company orders, purchasesand receives finished, completed, boxed and ready for sale video phone productsdirectly from its supplier.  The Companymakes no subsequent changes to the products. The Company does not maintain work in process inventory, component rawmaterials or supplies, except for very minimal quantities for repair work.  The Company does not include tooling,deferred start-up or general and administrative costs in its inventory costs.  The Company also does not maintain specificinventory for any specific long-term contracts or programs.  The Company tracks and removes inventory onlyunder the “first-in, first-out method” and prices it based upon the Company’sactual cost unless adjustments are required for obsolescence or for marketvaluations.  During the three monthsended June 30, 2006, the Company reduced inventory by $490 for suchadjustments.

Inventories as ofJune 30, 2006 and December 31, 2005 are summarized as follows:

|                 | ** ** | **June 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|-----------------|------------|-------------------------|------------|-----------------------------|------------|
| Raw material    |       | $                       | 0          |                        | $          | 0 |   |
| Finished goods  |       | 1,958                   |       | 2,878                       |       |
| Total Inventory |       | $                       | 1,958      |                        | $          | 2,878 |   |

 

6.             Stock Based Compensation.

Effective January1, 2006, the Company adopted the fair value recognition provisions of SFAS No.123 (Revised 2004), “Share-Based Payment,” using themodified-prospective-transition method. As a result, the Company’s net lossbefore taxes for the three and six months ended June 30, 2006 is approximately$225($0.01 per share), and $416($0.01 per share), respectively, greater than ifit had continued to account for share-based compensation under APB Opinion No.25 “Accounting for Stock Issued to Employees.”

Prior to January1, 2006, the Company’s stock-based employee compensation plans were accountedfor under the recognition and measurement provisions of  APB No. 25, and related Interpretations, aspermitted by FASB Statement No. 123, “Accounting for Stock-Based Compensation.”  The Company did not recognize stock-basedcompensation cost in its statement of operations for periods prior to January1, 2006 as all options granted had an exercise price equal to the market valueof the underlying common stock on the date of grant. However, compensationexpense was recognized for certain options granted to non employees of theCompany based upon fair value.

As was permittedunder SFAS No. 148, “Accounting for Stock-Based Compensation - Transition andDisclosure,” which amended SFAS No. 123, the Company elected to continue tofollow the intrinsic value method in accounting for its stock-based employeecompensation arrangements as defined by APB No. 25, and related interpretationsincluding FASB Interpretation No. 44, “Accounting for Certain TransactionsInvolving Stock Compensation,” an interpretation of APB No. 25. No stock-basedemployee compensation cost is reflected in operations, as all options grantedunder those plans had an exercise price equal to the market value of theunderlying common stock on the date of grant. The following table illustratesthe effect on net (loss) income and net (loss) income per share as if theCompany had applied the fair value recognition provisions of SFAS No. 123 tostock-based employee compensation:

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|                                                                                                                              | ** ** | **Three Months  Ended June 30,  2005** | ** ** | **Six Months  Ended June 30,  2005** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------|------------|-----------------------------------------------------|------------|
| Net (loss)  income, as reported                                                                                              |       | $                                                     | (366       | )                                                   | $          | 2,228 |   |
|                                                                                                                         |       |                                                  |       |                                                |       |
| Less:  Stock-based employee compensation expense determined under fair value-based  method for all awards, net of income tax |       | (206                                                  | )          | (400                                                | )          |
| Pro forma net  (loss) income                                                                                                 |       | $                                                     | (572       | )                                                   | $          | 1,828 |   |
|                                                                                                                         |       |                                                  |       |                                                |       |
| Net (loss)  income per share:                                                                                                |       |                                                  |       |                                                |       |
|                                                                                                                         |       |                                                  |       |                                                |       |
| Net (loss)  Income - as reported:                                                                                            |       |                                                  |       |                                                |       |
| Basic                                                                                                                        |       | $                                                     | (0.01      | )                                                   | $          | 0.07 |   |
|                                                                                                                         |       |                                                  |       |                                                |       |
| Fully Diluted                                                                                                                |       | $                                                     | (0.01      | )                                                   | $          | 0.06 |   |
|                                                                                                                         |       |                                                  |       |                                                |       |
| Net (loss)  income — pro forma:                                                                                         |       |                                                  |       |                                                |       |
| Basic                                                                                                                        |       | $                                                     | (0.02      | )                                                   | $          | 0.06 |   |
|                                                                                                                         |       |                                                  |       |                                                |       |
| Fully Diluted                                                                                                                |       | $                                                     | (0.02      | )                                                   | $          | 0.05 |   |

 

A summary of the Company’s stock plan is presentedbelow:
| ** **                           | ** ** | **Stock Options** | ** ** | **Weighted-Average  Exercise Price** | ** ** | **Aggregate Intrinsic  Value (in thousands)** | ** ** |
|--------------------------------------|------------|------------------------|------------|-------------------------------------------|------------|--------------------------------------------------------------|------------|
| Outstanding,  December 31, 2005 |       | 4,481,015              |       | $                                         | 1.94       |                                                         |       |   |
|                                 |       |                   |       |                                      |       |                                                         |       |
| Granted                              |       | 133,795                |       | $                                         | 1.86       |                                                         |       |   |
| Exercised                            |       | (29,795                | )          | $                                         | 1.34       |                                                         |       |   |
| Cancelled/forfeited                  |       | (14,867                | )          | $                                         | 3.75       |                                                         |       |   |
| Outstanding,  June 30, 2006          |       | 4,570,148              |       | $                                         | 1.93       |                                                         | $          | 2,294 |   |
| Exercisable, June 30,  2006          |       | 2,687,354              |       |                                      |       | $                                                            | 1,323      |   |

 

The following tablesummarizes information about stock options outstanding at June 30, 2006:

 

|                                             | ** ** | **Stock Options Outstanding** | ** ** | **Stock Options Exercisable**                           | ** ** |
|---------------------------------------------|------------|-----------------------------------------|------------|-------------------------------------------------------------------|------------|
| **Range of Exercise Prices** | ** ** | **Shares**                              | ** ** | **Weighted-  Average  Remaining  Contractual  Life (Years)** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Shares** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** |
| $0.24 - $0.39                               |       | 306,525                                 |       | 6.68                                                              |       | $ | 0.37 |   | 227,398 |   | $ | 0.37 |   |
| $0.40 - $0.59                               |       | 1,288,142                               |       | 7.25                                                              |       | 0.53 |   | 713,892 |   | 0.54 |   |
| $0.60 - $0.89                               |       | 10,000                                  |       | 7.29                                                              |       | 0.62 |   | 5,000 |   | 0.62 |   |
| $0.90 - $1.34                               |       | 779,250                                 |       | 7.48                                                              |       | 1.06 |   | 394,375 |   | 1.06 |   |
| $.1.35 - $2.01                              |       | 465,461                                 |       | 6.05                                                              |       | 1.74 |   | 375,336 |   | 1.72 |   |
| $2.02 - $3.02                               |       | 1,099,623                               |       | 6.70                                                              |       | 2.56 |   | 696,706 |   | 2.59 |   |
| $3.03 - $4.53                               |       | 433,512                                 |       | 7.94                                                              |       | 4.23 |   | 126,312 |   | 4.35 |   |
| $4.54 - $6.80                               |       | 112,533                                 |       | 6.47                                                              |       | 5.90 |   | 73,233 |   | 6.17 |   |
| $6.81 - $10.20                              |       | 40,000                                  |       | 4.63                                                              |       | 8.25 |   | 40,000 |   | 8.25 |   |
| $10.21 - $15.30                             |       | 0                                       |       | 0                                                                 |       | 0 |   | 0 |   | 0 |   |
| $15.31 - $22.95                             |       | 31,046                                  |       | 3.61                                                              |       | 20.44 |   | 31,046 |   | 20.44 |   |
| $22.96 - $34.43                             |       | 4,056                                   |       | 4.01                                                              |       | 28.60 |   | 4,056 |   | 28.60 |   |
|                                        |       | 4,570,148                               |       | 6.99                                                              |       | $ | 1.93 |   | 2,687,354 |   | $ | 2.02 |   |

 

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7.             Accounting for Preferred Shares and Derivative Shares.

InJune 2004, WorldGate completed a private placement of preferred stock. Thepreferred stock has a dividend rate of 5% per annum, payable quarterly, eitherby cash or through the issuance of common stock at the Company’s option. Thepreferred stock has a staged maturity over three years with scheduled paymentsof one third due after 18 months, one half of the remainder due after 24 monthsand the balance due after 36 months, and may be redeemed at maturity in cashor, at the Company’s option, subject to certain conditions that may not besolely under the control of the Company, through the issuance of the number ofshares of common stock determined by dividing the liquidation preference of thepreferred shares by the then average market price over the ten consecutivetrading days prior to the date of conversion.  If the effectiveness of theregistration statement lapses, the Company ceases to be listed on certainspecified exchanges and trading in the Company’s stock is suspended or a changein control occurs with respect to the Company, the Company may be required tosettle redemption of the preferred stock with cash instead of its commonshares.  Furthermore, since the market price of the Company’s common stockcannot be predicted, the actual number of shares of the Company’s common stockthat will be required if a redemption is made through the issuance of commonstock also cannot be predicted. The private placement includes numerousprovisions intended to protect these institutional investors including a cashpayment penalty of 1.0% per month for unredeemed preferred shares onceregistration of the shares lapse and until the registration again becomeseffective.

The preferred stock has embedded conversion options.Specifically, the holders of the preferred stock may convert their shares intothe Company’s common stock at a conversion price of $2.35 per share. Inaddition the Company may force conversion of the preferred stock into commonstock if the Company achieves certain price targets for its common stock andsatisfaction of certain other conditions, such as the existence of an effectiveregistration statement. In either event the conversion price is subject toadjustment if, at any time after the date the preferred shares were issued, theCompany issues or sells, or is deemed to have issued or sold, any shares of theCompany’s common stock for per share consideration less than the conversionprice of the preferred shares on the date of such issuance or sale. Accordingly, the number of common shares issuable upon the conversion of thepreferred shares cannot be predicted.  Furthermore, net-cash settlementmay be required in the event of conversion default under certain circumstancesthat may not be solely under the control of the Company.  If theeffectiveness of the registration statement lapses, the Company ceases to belisted on certain specified exchanges and trading in the Company’s stock issuspended or a change in control occurs with respect to the Company, theCompany may be required to settle a conversion of the preferred stock with cashinstead of its common shares.

Also, as part of the private placement the Companyissued five-year warrants to purchase up to 803,190 shares of our common stockat an exercise price of $2.69 per share and five-year warrants to purchase upto 803,190 shares of our common stock at an exercise price of $3.14 per share.The investors also received an additional investment right, for a limitedperiod of time, to purchase 1,606,383 additional shares of common stock sharesat $3.14 a share. This exercise price of the warrants is subject to adjustmentif, at any time after the date the warrants were issued, the Company issues orsells, or is deemed to have issued or sold, any shares of the Company’s commonstock for per share consideration less than the exercise price of the warrantson the date of such issuance or sale.  Accordingly, the number of commonshares that will be issued upon the exercise of the warrants cannot bepredicted.  As of June 30, 2006, 125,000 warrants exercisable at$2.69 had been exercised and 51,915 warrants exercisable at $3.14 had beenexercised.  All of the additional investment rights had been exercised asof June 30, 2006.

Of the 7,550preferred shares issued under this private placement, 7,384 shares have beenredeemed as of June 30, 2006.

With respect to the Company’s accounting for thepreferred stock, Emerging Issues Task Force (“EITF”) Topic D-98, paragraph 4,states that Rule 5-02.28 of Regulation S-X requires securities withredemption features that are not solely within the control of the issuer to berecorded outside of permanent equity. As described above, the terms of thepreferred stock include certain redemption features that may be triggered byevents that are not solely within the control of the Company, such as apotential failure in the Company’s ability to maintain an effectiveregistration statement. Furthermore, the actual number of shares of commonstock required to satisfy redemption is based upon the market value of thecommon stock at the time of the redemption, which cannot be predicted.Accordingly, the Company has classified the preferred stock as temporary equityand the value ascribed to the redeemable preferred stock upon initial issuance,i.e. at June 24, 2004, was the amount received in the transaction minusthe fair value ascribed to the conversion options and warrants. The initialvalue of the redeemable preferred stock is accreted up to the redemption value(the amount received in the transaction) over the future relevant periods usingthe interest method. The value of the redeemable preferred stock at June 30,2006 was $148.

The terms of the preferred stock include certainconversion options that represent derivative financial instruments underparagraph 12 of SFAS No. 133 and thus were separated from the preferredstock and valued using the Black-Scholes

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optionpricing model.  The conversion options include certain provisions thatcould result in a variable number of shares to be issued upon conversion,adjustment to the strike price at which conversion shares will be determined,or the requirement for the Company to settle the conversion options incash.  EITF 00-19, “Accounting forDerivative Instruments Indexed to, and Potentially Settled in, a Company’s OwnStock,” states that if the conversion options require net cash settlement inthe event of circumstances that are not solely within the Company’s controlthey should be classified as a liability measured at fair value on the balancesheet.

The terms of the five-year warrants include cashpenalty provisions in the event that the Company fails to meet its obligationsto deliver registered shares to the warrant holder upon exercise and ananti-dilution provision that could result in a variable number of shares to beissued upon warrant exercise. Additionally, the terms and conditions of thewarrants provide for net settlement through cashless exercise whereby theshares delivered to the warrant holder would be readily convertible to cash. Inaccordance with EITF 00-19 and given the terms and conditions of the warrantsas outlined above, the Company has classified the warrants as a liability onits balance sheet measured at fair value using the Black-Scholes option pricingmodel.

The Company accounts for both the conversion optionsand warrants using the fair value method at the end of each quarter, with theresultant gain or loss recognition recorded against earnings. Both the warrantsand conversion options are valued using the Black-Scholes valuation model.Actual period close common stock prices, applicable volatility rates, and theperiod close risk-free interest rate for the instrument’s expected remaininglife (continuously compounded), are the key assumptions used in the valuationcalculation.  The result was a $520 and$339, respectively, non cash charge for the three and six months endedJune 30, 2006, and a non cash gain of $2,466 and $7,642, respectively, forthe three and six months ended June 30, 2005

8.             Warranty Reserve.

The Company provides awarranty covering defects arising from the sales of its video phone product.This warranty is limited to a specific time period. As of June 30, 2006, theCompany has a reserve of $89 that is based on a percentage of productsales.  As of June 30, 2006, theCompany has not incurred any material warranty costs related to our product.Warranty costs are charged to cost of revenues when they are probable andreasonably estimable. While we believe our estimate at June 30, 2006 isreasonable and adequate, it is subject to change based on our future sales andexperience, which may require an increase or decrease in our reserve.

During the three and sixmonths ended June 30, 2006, the Company reduced its warranty reserve of $336 atDecember 31, 2005 by $1 and $232, respectively. This adjustment, recorded as an increase to the gain recorded from thetermination on February 17, 2006 of the Company’s agreement with GeneralInstrument, is a result of the elimination of the warranty exposure forproducts previously sold and then repurchased from General Instrument underthis termination.

9.             Commitments and Contingencies.

*Leases*

The Company’s currentlease was signed on September 1, 2005 and covers 42,500 square feet at an annualrate of $11.40 per square foot with a 3% increase annually, cancelable byeither party with eight months notice, with a termination by tenant alsoincluding six months termination fee. Total rent expense for the three months ended June 30, 2006 and 2005amounted to approximately $159 and $62, respectively.  Total rent expense for the six months endedJune 30, 2006 and 2005 amounted to approximately $318 and $153, respectively.

In November 2003,the Company entered into a 60 month lease for office equipment. As ofJune 30, 2006, there remains a total of $14 to be paid over the remainingperiod of this lease.  InOctober 2005, the Company entered into a 36 month lease for officeequipment. As of June 30, 2006 there remains a total of $17 to be paidover the remaining period of this lease.

The future minimumcommitments under non-cancelable leases for the balance of each of the fiscalyears ending December 31 are as follows:

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|                                                | ** ** | **(Dollars in  Thousands)** | ** ** |
|------------------------------------------------|------------|----------------------------------|------------|
| 2006 (July 1,  2006 through December 31, 2006) |       | $                                | 254        |   |
| 2007                                           |       | 517                              |       |
| 2008                                           |       | 530                              |       |
| 2009                                           |       | 535                              |       |
| 2010                                           |       | 363                              |       |
| Total                                          |       | $                                | 2,199      |   |

 

*Significant Agreements andTransactions*

Net revenues fromcontinuing operations recognized from General Instrument, an investor, wereapproximately $0 and $1,399, respectively, for the three months endedJune 30, 2006 and 2005 respectively. Net revenues from continuing operations recognized from GeneralInstrument, an investor, were approximately $0 and $1,577, respectively, forthe six months ended June 30, 2006 and 2005 respectively. This investoraccounted for approximately 100% of the revenues for the three and six monthsended June 30, 2005.  This investorpreviously provided a cash advance against product shipments. The balance ofthis advance received from this investor was $0 at each of June 30, 2006and 2005, respectively. Accounts receivable from this investor was $0 and $123as of June 30, 2006 and December 31, 2005, respectively. In April andSeptember 2004, we issued warrants to this investor to purchase shares ofour common stock, with the April warrants having an exercise price of$1.4375 per share and the September warrants having an exercise price of$1.75 per share. Included in General and Administrative expenses inSeptember 2004 were $606 of expenses relating to the valuation of thesewarrants. This valuation was determined by using the Black-Scholes fair valueoption model. The following assumptions were used: expected volatility of 65%;average risk-free interest rate of 3.43%; dividend yield of 0%; and an expectedlife of 5.0 years.

On April 28, 2004,the Company entered into a six-year distribution agreement with GeneralInstrument for the marketing and distribution of the Ojo video phone. Thisagreement provided for General Instrument to be WorldGate’s exclusivedistributor of its broadband video phone products and for WorldGate to beGeneral Instrument’s exclusive supplier of its broadband video phone products.After a period of eighteen months following the commercial availability of theOjo video phone, this mutual exclusivity would terminate unless GeneralInstrument elected to continue the mutual exclusivity after having achievedcertain minimum sales targets for the Ojo video phone. General Instrument couldhave, however, at its option, elected to terminate this mutual exclusivity atany time. In the event mutual exclusivity terminates or is terminated, then fora twelve month period thereafter, WorldGate was to continue to be GeneralInstrument’s exclusive supplier of broadband video phones, but would be free tosell video phone products to customers other than certain defined GeneralInstrument accounts. During this twelve month period, General Instrument had aright of first refusal to accept and fill any orders for video phone productsthat WorldGate obtained from non-General Instrument accounts, and was obligatedto use good faith efforts to solicit and accept product orders from GeneralInstrument accounts in a commercially reasonable manner. During any period ofexclusivity under this agreement the Company was reliant upon GeneralInstrument and its distribution partners, including, for example, wholesalers,retailers and service providers, to provide the worldwide sales anddistribution of the Ojo video phone. Although the agreement required GeneralInstrument to provide for certain marketing and promotional activities for theOjo video phone, there were no required sales quotas for the agreement toremain in effect, and General Instrument controlled the volume of productsbeing distributed by our Company. Neither party was permitted to terminate theagreement except in cases of uncured breaches of the agreement or as a resultof insolvency events suffered by the other party. If General Instrument and itspartners were not successful, or if their activities did not lead tosignificant sales of our product, our operating results could have beenadversely affected, our revenue could be significantly reduced and the Companycould lose potential customers.  Inconnection with the Development and Distribution Agreement with GeneralInstrument, the Company issued warrants to General Instrument to purchase600,000 shares of our common stock, 300,000 at an exercise price of $1.4375 pershare with the execution of the agreement in April 2004, and 300,000 at anexercise price of $1.75 upon the delivery to General Instrument of acceptableprototypes for the product. Additionally, the Company agreed to issue warrantsto purchase up to an additional 1,650,000 shares of our common stock, upon theachievement of certain sales milestones, at an exercise price based upon theaverage closing sales price of our common stock during the 20 day periodpreceding the issuance of each warrant.

On February 17,2006, the Company mutually agreed with General Instrument to end their mutuallyexclusive distribution agreement.  Theending of this agreement immediately terminated this exclusivity for bothparties, and accordingly enabled WorldGate to expand its focus in bringing Ojoto the marketplace. In addition to its current role for development andmanufacture of Ojo, WorldGate became directly responsible for the advertising,marketing, and distribution of its products.

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Based upon ouractual experience to date, the Company does not believe it is necessary toestablish a reserve for retailer returns to General Instrument.  In the Company’s discussions with theretailers eligible for such returns, the retailers have indicated theirintention to continue to sell the Company’s video phone products and, to datethe Company has not received any returned products.

As part of endingthe development and distribution agreement, General Instrument has agreed tocertain restrictions on its development of a stand-alone video phone productwhich has as a primary function the making or receipt of video phone calls overa broadband network.  Such restrictions will end in January 2007.

The Company has a currenttwo year agreement with Mototech , an investor, to provide the Company withengineering and development support. As a result of this agreement, the Companyhas expensed approximately $181 and $92, respectively for the three monthsended June 30, 2006 and 2005. For the six months ended June 30, 2006 and 2005,the Company expensed approximately $200 and $158, respectively. Accounts payableto this investor amounted to $1,181and $1,173 at June 30, 2006 andDecember 31, 2005, respectively. This agreement provided for contractedservices, including hardware and software development, and the creation anddevelopment of tools to facilitate the Company’s engineering efforts. Thisagreement does not provide for ongoing royalties, purchase provisions, or forany requirement to provide additional funding to the Company.  Net revenues from operations recognized fromMototech were approximately $2 and $0 for the three months ended June 30,2006 and 2005, respectively.  Netrevenues from operations recognized from Mototech were approximately $395 and$0 for the six months ended June 30, 2006 and 2005, respectively.  This investor accounted for approximately 1%and 0% of the revenues for the three months ended June 30, 2006 and 2005,respectively, and 57% and 0% of the revenues for the six months endedJune 30, 2006 and 2005, respectively. Accounts receivable from this investor were $7 and $0, respectively, asof June 30, 2006 and December 31, 2005.

In June 2004, WorldGatecompleted a private placement of 7,550 shares of preferred stock at a statedvalue of $1,000 per share. The preferred stock has attached warrants andconversion options. Specifically, the holders of the preferred stock mayconvert their shares into our common stock at a conversion price of $2.35 pershare. The private placement includes numerous provisions intended to protectthese institutional investors including a cash payment penalty of 1.0% permonth for unredeemed preferred shares once registration of the shares lapse anduntil the registration again becomes effective. A registration statement forthese securities was originally filed containing fiscal 2003 financial statements,and an amendment to this registration statement which included fiscal 2005financial statements was not registered until June 1, 2006.  Until such time as the shares becomeregistered the Company was subject to the penalty provision under this privateplacement.

In August 2005,the Company completed a private placement for $17,500 of its common stock andwarrants with several institutional investors. The Company issued 4,666,664shares of its common stock at $3.75 per share to the participating investors.The Company also issued five-year warrants to purchase a total of 1,671,947shares of its common stock: 1,633,333 shares to the investors at an exerciseprice of $5.00 per share, and 38,614 shares to the placement agent at anexercise price of $4.53 per share.  The investors also received anadditional investment right, for a limited period of time, to purchase1,554,000 additional shares of common stock at $4.12 per share.  The private placement includes numerousprovisions intended to protect these institutional investors including a cashpayment penalty of 1.5% per month for the period above 120 days fromthe effective date of the agreement that the shares in the transactionfail to be registered. The Registration Statement covering the shares under thisprivate placement was not declared effective until June 1, 2006.  Until such time as the shares were registeredthe Company was subject to the penalty provision under this private placement.For the three months ended June 30, 2006 and 2005 the Company recorded andexpensed related penalties of $599 and $0, respectively.  For the six months ended June 30, 2006 and2005 the Company recorded and expensed related penalties of $1,387 and $0,respectively. The related unpaid penalties accrued as of June 30, 2006 andDecember 31, 2005 was $630 and $525, respectively.  On July 25, 2006, the Company amended theterms of the additional investment right that was granted to an investor aspart of the August 2005 private placement, with respect to a portion of shares ofcommon stock purchasable thereunder and agreed to apply $158 of accruedpenalties towards the exercise price of such amended additional investmentright, for the purchase of 129,950 shares of common stock. The penalties hadaccrued with respect to the Company’s inability to register the shares acquiredby such investor in the private placement within 120 days of thetransaction.  In consideration for thisamendment and application of the exercise proceeds the investor agreed toforego any cash payment of the penalties other than as available through theproceeds of the exercise of the amended investment right and to grant to theCompany a release of all claims relating to the late registration of theprivate placement shares, other then the aforesaid penalties.  The amendedadditional investment right provides that the investor thereof may purchase the129,950 shares of common stock for a period of 760 days beginning June 1, 2006for an exercise price of $1.515 per share.  The terms of the additionalinvestment rights with respect to the remaining 1,424,050 shares of commonstock purchasable thereunder remain unchanged. On July 26, 2006 this investor exercised the additional investment rightfor 129,950 shares.

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10.           Net Loss per Share.

Basic and dilutednet income (loss) per common share is computed by dividing the net income(loss) available to common stockholders for the period by the weighted averagenumber of shares of common stock outstanding during the period.  The calculation of diluted net income (loss)per common share excludes potential common shares if the effect isantidilutive.  Potential common sharescomprise shares of common stock issuable upon the exercise of stock options andwarrants.  The number of potential commonshares which would have been assumed to be converted in the three and sixmonths  ended June 30, 2006 and have adilutive effect if the Company had income from continuing operations, or if theoptions’ exercise price was less than the average market price of the commonshares, is 10,937,951 and 10,937,951, respectively, and for the three and sixmonths ended June 30, 2005, the number of shares are 6,021,103 and 1,936,170,respectively.

11.           Stock Options and Warrants.

In October 2004, theCompany’s stockholders approved the 2003 Equity Incentive Plan (“2003 Plan”).This plan is intended to replace the 1996 Plan for new grants. No additionalshares were reserved for the new plan but rather all available shares under the1996 Plan were made available for the new plan. As with the 1996 Plan, the 2003Plan includes the same automatic annual increase in the number of sharesreserved for use with the plan equal to the greater of 4% of the thenoutstanding shares of the Company’s common stock or 1,000,000 shares. Inaddition to ISOs and NQSOs, the new plan also provides for performance basedawards and restricted stock.  At June 30,2006, there were 8,085,730 shares reserved under these plans, and 4,599,943options outstanding.  During the threeand six months ended June 30, 2006, there were 75,795 and 133,795,respectively, options granted to employees and a consultant.  During the three and six months ended June30, 2006, there were 29,795 options exercised.

At June 30, 2006there were a total of 6,297,165 warrants outstanding (for more details, referto Note 3).

12.           Revenue Recognition.

Revenue is recognized when persuasive evidence of anarrangement exists, the price is fixed or determinable, the collectibility isreasonably assured, and the delivery and acceptance of the equipment has occurredor services have been rendered.  Management exercises judgment inevaluating these factors in light of the terms and conditions of its customercontracts and other existing facts and circumstances to determine appropriaterevenue recognition. Due to our limited commercial sales history, our abilityto evaluate the collectibility of customer accounts requires significantjudgment. The Company evaluates its equipment customer and service customers’accounts for collectibility at the date of sale and on an ongoing basis.

For the yearsended December 31, 2004 and 2005, and through mid February 2006, the Companyhad only one customer for the purchase of its product and the agreement withthis customer included several elements relevant to revenue recognitionincluding: (a) the customer had no general right to return theproduct;  (b) the customer earned warrants upon the purchase ofsignificant video telephony units and the value of these warrants would resultin a reduction of recognized revenue (the value of these warrants has beenroutinely monitored by the Company and is currently deemed to be insignificant,however, should the value of these warrants become material an offset would bemade against revenues); (c) penalties are payable to the customer ifcertain excessive field failure rates are exceeded;  (d) the Companyand the customer share in the benefit achieved by product cost reductions;(e) penalties are payable to the customer if the Company fails to delivershipments on a timely basis; (f) the Company extends to the customer alimited product warranty for a term not to exceed three years (the Companymaintains a warranty reserve based upon the percentage of product salesconsistent with industry comparable failure rates and the warranty period providedby the agreement).  Beginning in midFebruary 2006, as a result of the termination of the General Instrumentmarketing and distribution agreement, the Company began selling its products tomultiple customers and now evaluates its revenue recognition policy on acustomer by customer basis.

Revenues are also offset by a reserve for any pricerefunds and consumer rebates consistent with the EITF Issue 01-9, “Accountingfor Consideration Given by a Vendor to a Customer.”

As an incentive to promote delivery of the units, aspecial product launch discount was provided by the Company to a distributor asa quantity restricted reduction to the unit contract based price in effect. Forthe year ended December 31, 2005, this discount was $398.  In addition, the Company offered a forwardpricing program to its former distributor and a rebate program to consumers, asfurther incentives for the 2005 holiday season. These incentive programs beganin the fourth quarter

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of 2005and terminated during the first quarter of 2006. Consistent with the EITF Issue01-9, the Company has offset its revenues for the year ended December 31,2005 by $212 for a reserve for the total estimated liability for the forwardpricing program, and $91 as an estimated liability associated with the rebateprogram.  The total of the product launch discount, refunds and rebatesfor the year ended December 31, 2005 was $701.  There were no product launch discounts,refunds or rebates for the years ended December 31, 2003 and 2004 and for thethree and six months ended June 30, 2005.  The forward pricing program was terminated with the termination onFebruary 17, 2006 of the distribution agreement with General Instruments, andthis liability was reversed and recorded as a $212 increase to the gain realizedfrom termination of this agreement.  OnMarch 13, 2006, the Company announced that it was going to offer a new consumerrebate program effective April 1, 2006 and terminating June 30, 2006.  At June 30, 2006, there was an estimatedliability of $83 associated with this rebate program.  Also, on March 13, 2006 the Company announceda price protection program for certain retailers holding Ojo video phoneinventory as of April 1, 2006.  At June30, 2006, there was an estimated liability of $18 associated with this priceprotection program.  These rebate andprice protection programs were recorded as offsets against revenues in thethree and six months ended June 30, 2006.

As part of endingits agreement with General Instrument, and in anticipation of WorldGateinventory requirements as a result of taking full responsibility for productdistribution, WorldGate negotiated the right to buy back about two-thirds ofthe units sold to General Instrument, valued at approximately $2,765 (basedupon the original sales price to General Instrument), for approximately $1,064.This is less than half of what it would cost the Company to purchase the sameinventory from its manufacturing sources. As a result the Company recorded a reserve for returns and reduced revenuein the amount of approximately $2,310, during the fourth quarter of 2005. Inaddition, the Company has recorded no revenue for units shipped to GeneralInstrument in the first quarter 2006 and has recorded a gain on termination ofthis agreement of approximately $1,792 during the first quarter 2006 as aresult of the lower purchase price of the inventory repurchased from GeneralInstrument ($1,342, net of the cost of rework for rebranding the product andthe adjustment of the inventory to its current replacement value) and reversalof the product refund program reserve ($212) as well as an adjustment of thewarranty reserve for products repurchased ($233), both of which resulted fromtermination of the Company’s agreement with General Instrument.

13.           Risksand uncertainties.

Our primary line ofbusiness is the development of video phone products and technology. We arestill in the process of launching our first product based on this technologyand, although we have realized some revenues for the commercial sale of ourproduct, the revenues to date have not been substantial. Given the early stageof our product and the lack of operating history in the video phone business,it is difficult to predict our future results.

On April 28, 2004,we entered into a multi-year agreement with General Instrument for theworldwide development and distribution of the Ojo personal video phone. Thisagreement provided for General Instrument to be WorldGate’s exclusivedistributor of its broadband video phone products and for WorldGate to beGeneral Instrument’s exclusive supplier of its broadband video phoneproducts.  On February 17, 2006, wemutually agreed with General Instrument to end this agreement.  The ending of this agreement immediatelyterminated this exclusivity for both parties, and accordingly enabled WorldGateto expand its focus in bringing Ojo to the marketplace. In addition to itscurrent role for development and manufacture of Ojo, WorldGate became directlyresponsible for the advertising, marketing, and distribution of its products. Subsequentto the ending of the agreement with General Instrument we will depend upondistribution partners, including, for example, wholesalers, retailers andservice providers, to provide the worldwide sales and distribution of the Ojovideo phone. If our partners are not successful, or if their activities do notlead to significant sales of our product, our operating results will beadversely affected, our revenue could be significantly reduced and we couldlose potential customers.

Wealso depend on relationships with third parties such as contract manufacturingcompanies, chip design companies and others who may be sole source providers ofkey components and services critical for the product we are developing in ourvideo phone business. A formal relationship with Mototech has been establishedfor the volume manufacture of Ojo. Our agreement with Mototech allows eitherparty to terminate the agreement with 90 days prior notice. If Mototech orother providers of components and/or manufacturing services do not producethese components or provide their services on a timely basis, if the componentsor services do not meet our specifications and quality control standards, or ifthe components or services are otherwise flawed, we may have to delay productdelivery, or recall or replace unacceptable products. In addition, suchfailures could damage our reputation and could adversely affect our operatingresults. As a result, we could lose potential customers and any revenues thatwe may have at that time may decline dramatically.

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14.           Subsequent Event.

 

On August 11, 2006 theCompany completed a private placement with an institutional investor of aconvertible debenture in the aggregate principal amount of up to $11,000.  This debenture has a maturity of three years,an interest rate of 6% per annum, and is convertible at the option of theinvestors into WorldGate common stock at a conversion price equal to the lesserof $1.75 per share or 90% of the average of the five lowest daily volumeweighted average closing price (“VWAP”) of the common stock during the fifteentrading days immediately preceding the conversion date (subject to adjustmentin the event of stock dividends and splits and certain distributions tostockholders, fundamental transactions, and future dilutive equitytransactions).  Interest is payable at maturity, and we may elect to paythe interest amount in cash or shares of our common stock.  

 

The Company received $6,000upon the closing of the deal ($5,600, net of deal costs).  An additional $3,000 will be funded upon stockholderapproval of the transaction and $2,000 upon an effective registration of theshares of common stock issuable in the transaction.

 

The Company has the rightto redeem all or any portion the principal amount of the debenture in cash atany time upon not less than four business days notice if the closing price ofour stock is less than $1.75 per share.  Such early redemption will,however, require us to pay a 10% prepayment premium.   In addition,without any prepayment premium, we have the right to force the holders toconvert a maximum of $500 of the principal amount of the debenture in anythirty day period if for five consecutive trading days the VWAP of our commonstock is above $1.925 per share but less then $3.50 per share and providing thedaily trading volume exceeds 200,000 shares for these five days, and certainother conditions are met.  If the VWAP ofour common stock is greater than $3.50 per share for 30 consecutive tradingdays, the daily trading volume exceeds 250,000 shares for five days prior, andif certain other conditions are met, we can also force the holder to convertall or any portion of the outstanding principal and interest into shares of ourcommon stock without any prepayment premium.

 

There are somerestrictions on the holder’s right to convert the debenture.  The holder cannotmake any conversions below $1.75 per share (i) until the earlier of the dateregistered common stock can be issued pursuant to such conversion or January 1,2007, (ii) which would exceed $500 in principal amount in any calendar month,or (iii) which would result in the issuance of more than 840,000 shares of ourcommon stock per calendar month (provided that this maximum share limit will bewaived by the Company unless it elects to pay the holder in cash the differencein value between 840,000 shares and the number of shares the holders wishes toconvert, up to the $500 per month conversion limit).  If we are in defaultunder the debenture these limitations are waived. The holder is also not restrictedin making conversions at $1.75.  In nocase, however may the holder convert the debentures if (x) it would result inbeneficial ownership of more than 9.99% of our outstanding common stock (thoughthis provision can be waived by the holder upon 65 days prior notice), or (y)such conversion would, without stockholder approval, cause the Company to issuemore than 19.99% of its outstanding shares as determined immediately prior toconsummation of the transaction.  Under certain circumstances, thedebenture holders are entitled to have the conversion price adjusted tocorrespond to common stock holders’ rights to any stock dividend, stock split,stock combination or reclassification of shares. The $1.75 conversion price isalso subject to a weighted average dilution adjustment if we issue shares(apart from certain excluded issuances) of our capital stock at an effectiveprice of less than $1.75 per share.  We also granted the debenturesholders a security interest in all of our assets.  Moreover, the Company is required to registerthe shares of common stock issuable to the investor for resale to the publicpursuant to a registration rights agreement, containing customary terms,conditions and indemnities.  The privateplacement includes numerous provisions intended to protect the institutionalinvestors including a cash payment penalty of 1.0% per month for the periodabove 120 days from the effective date of the agreement that the shares in thetransaction fail to be registered with the aggregate penalty capped at 12%.

 

In addition, theaggregate number of shares to be issued upon conversion, exercise of thewarrants, payment for commitment shares, and payment of liquidating damagespursuant to the registration rights agreement has been limited to 61,111,111shares of common stock.  

 

As part of this privateplacement the Company will issue five-year warrants to purchase a total of up to 2,595,000 shares ofWorldGate common stock, with 1,145,000 of the warrants having an exercise priceof $1.85 per share (with 624,545 of these warrants issued at closing and520,455 warrants issued upon stockholder approval of the transaction),1,100,000 of the shares having an exercise price of $2.35 per share (with600,000 of these warrants issued at closing and 500,000 warrants issued uponstockholder approval of the transaction), and 350,000 warrants having anexercise price of $2.60 per share (with 190,909 of these warrants issued atclosing and 159,091 warrants issued upon stockholder approval of thetransaction).

 

The Company is currentlyevaluating the accounting for this transaction.

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# ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

**FORWARD-LOOKINGAND CAUTIONARY STATEMENTS**

We may from timeto time make written or oral forward-looking statements, including thosecontained in the following Management’s Discussion and Analysis of FinancialCondition and Results of Operations.  Thewords “estimate,” “project,”“believe,”“intend,” “expect,” and similar expressions are intended to identifyforward-looking statements, although not all forward-looking statements containthese identifying words.  In order totake advantage of the “safe harbor” provisions of the Private SecuritiesLitigation Reform Act of 1995, we are hereby identifying certain importantfactors that could cause our actual results, performance or achievement todiffer materially from those that may be contained in or implied by anyforward-looking statement made by or on our behalf.  The factors, individually or in theaggregate, that could cause such forward-looking statements not to be realizedinclude, without limitation, the following: (1) difficulty in developing andimplementing marketing and business plans, (2) industry competition factors andother uncertainty that a market for our products will develop, (3) challengesassociated with distribution channels, including both the retail distributionchannel and HSD operators (e.g., uncertainty that they will offer our products,inability to predict the manner in which they will market and price ourproducts and existence of potential conflicts of interests and contractuallimitations impeding their ability to offer our products), (4) continuedlosses, (5) difficulty or inability to raise additional financing on termsacceptable to us, (6) departure of one or more key persons, (7) delisting ofour common stock from the NASDAQ Capital Market, (8) changes in regulatoryrequirements, and (9) other risks identified in our filings with the Securitiesand Exchange Commission.  We caution youthat the foregoing list of important factors is not intended to be, and is not,exhaustive.  We do not undertake toupdate any forward-looking statement that may be made from time to time by oron our behalf.

**Results of Operations:**

**General**

Our video phonebusiness has not produced significant revenues to date.  The extent andtiming of future revenues for our business depends on several factors,including the rate of market acceptance of our products and the degree ofcompetition from similar products.  We cannot predict to what extent ourvideo phone product will produce revenues, or when, or if, we will reachprofitability.

 OnApril 28, 2004, we entered into a multi-year agreement with GeneralInstrument Corporation d/b/a the Connected Home Solutions Business ofMotorola, Inc. (“General Instrument”) for the worldwide development anddistribution of the Ojo personal video phone. This agreement provided forGeneral Instrument to be WorldGate’s exclusive distributor of its broadbandvideo phone products and for WorldGate to be General Instrument’s exclusivesupplier of its broadband video phone products. On February 17, 2006, we mutually agreed with General Instrument to endthis agreement.  The ending of thisagreement immediately terminates exclusivity for both parties. In addition toits current role for development and manufacture of Ojo, WorldGate will nowhave direct responsibility and control for the advertising, marketing, anddistribution of its products.

Under ourdevelopment and distribution agreement with General Instrument, GeneralInstrument was responsible for the distribution of our products and for thedirect relationship with the distributors, dealers, and other resellersultimately used to sell the products.  Inaddition, General Instrument marketed our products and maintained an inventoryof our products.  In performing thesefunctions General Instrument carried the associated risks, costs andexpenses.  As a result of ending ouragreement with General Instrument, we are now directly assuming theseresponsibilities and the associated risks, costs and expenses, and this placesincreased demands on the cash which we have available.  Although General Instrument’s price of ourproduct to its reseller customers included a mark-up from its cost of theproduct from us that was intended to reflect its risks, cost and expenses, plusits profit, we will be charging these reseller customers a lower price and wecannot be assured that the new price will include a sufficient mark-up to coverthe risks, costs and expenses that is now our responsibility going forward.

Under itsagreement with General Instrument, WorldGate had been active in marketing andpromoting its products, and working with General Instrument to distribute Ojo.WorldGate intends to continue the rollout of Ojo using many of the same distributors,retailers and service providers and plans to expand distribution to serviceproviders and retailers around the world.  In addition to direct sales onour web site, we will continue to rely upon a distribution organization ofdealers, distributors, original equipment manufacturers, value added resellers,service providers and other resellers to market and sell our video phoneproducts, many of which will be the same as those used by GeneralInstrument.  To enable our own retail

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distribution efforts wehave hired an experienced retail consumer electronics executive to direct ourefforts in this area.    Under itsagreement with General Instrument, WorldGate’s video phone products wererequired to be co-branded with the Ojo brand (which WorldGate continued to own)and the Motorola brand.  As the result ofending our agreement with General Instrument, we will now be dropping theMotorola brand.

General Instrumentalso maintained the necessary infrastructure to handle distribution logistics,including customer ordering, inventory warehousing, billing, customer service,credit and accounts receivable functions multiple customers.  Until February 17, 2006 all of our revenuefor the sale of our video phones was derived from General Instrument, a singlecustomer, and there were minimal administrative costs associated with billingand collecting this revenue.  The Companywill now have multiple customers and bear the associated increasedadministrative costs and risks of collection. WorldGate will also need todevelop the necessary infrastructure to handle multiple customers and theseother logistical functions.

As part of endingour agreement with General Instrument, and in anticipation of WorldGateinventory requirements as a result of taking full responsibility for productdistribution, WorldGate negotiated the right to buy back about two-thirds ofthe units sold to General Instrument, valued at approximately $2,765 (basedupon the original sales price to General Instrument), for approximately $1,064.This is less than half of what it would cost the Company to purchase the sameinventory from its manufacturing sources. For more details, refer to Note 12 to our condensed consolidatedfinancial statements for the three and six months ended June 30, 2006.

The Company doesnot believe it is necessary to establish a reserve for retailer returns toGeneral Instrument.  In the Company’sdiscussions with the retailers eligible for such returns, the retailers haveindicated their intention to continue to sell the Company’s video phoneproducts and to date the Company has not received any returned products.

As part of endingthe development and distribution agreement, General Instrument has agreed tocertain restrictions on its development of a stand-alone video phone productwhich has as a primary function of the making or receipt of video phone callsover a broadband network.  Such restrictions will end in January 2007.

*CriticalAccounting Policies and Estimates.*

Our condensedconsolidated financial statements have been prepared in accordance withaccounting principles generally accepted in the United States.  These generally accepted accountingprinciples require management to make estimates and assumptions that affect thereported amounts of assets and liabilities and disclosure of contingent assetsand liabilities at the date of the financial statements and the reportedamounts of revenues and expenses during the reporting period.  Actual results could differ from thoseestimates.

Our significantaccounting policies are described in the notes to the consolidated financialstatements included in our annual report on Form 10-K.  Judgments and estimates of uncertainties arerequired in applying our accounting policies in many areas.  Following are some of the areas requiringsignificant judgments and estimates: revenue recognition, accounts receivable, inventories, cash flow andvaluation assumptions in performing asset impairment tests of long-livedassets, value of redeemable preferred stock, related warrants and conversionoptions.

Three and SixMonths Ended June 30, 2006 and June 30, 2005.

*Revenues.*

Revenues for thethree and six months ended June 30, 2006 were $186 and $696, respectively,primarily reflecting the initial product revenues from the Company’s directdistribution of the Ojo product subsequent to the termination of its exclusivedistribution agreement with its former distributor on February 17, 2006. Theserevenues represent deliveries of video phones and related service fees.Revenues during the three and six months ended June 30, 2005 were $1,399 and$1,577, respectively, and reflect product inventory build up by the Company’sformer distributor.  The reduction inrevenue during 2006 with respect to comparable periods in 2005, primarilyreflect the delay in our sales activities as a result of transitioning thereseller network of our former distributor and adding incremental directdistribution.  During the quarter endedJune 30, 2006 we shipped several thousand units to a customer with a right ofreturn should the units not be sold through to their customer.  In addition, we sold a thousand units to acustomer under an arrangement whereby we agreed to warehouse the units for themuntil such time as when they can accept delivery of these units.  Revenue for these units have been deferred asof June 30, 2006 in accordance with FAS 48 “Revenue Recognition when a Right ofReturn Exists” and SAB Topic 13 “when a Bill and Hold Condition Exist”.However, we do expect to begin recording these shipments as revenue in thethird quarter of 2006.

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On March 13, 2006,as an incentive to promote delivery of the units, the Company announced aspecial price protection program to certain retailers and a rebate program toconsumers. These incentive programs began on April 1, 2006 and terminated atthe end of the second quarter of 2006. Consistent with the EITF Issue 01-9,Accounting for Consideration Given by a Vendor to a Customer, we offset ourJune 30, 2006 revenues by $24 and $35 respectively, for the price protectionprogram and $44 and $24, respectively, for the consumer rebate program for thethree and six months ended June 30, 2006. For more details, refer to Note 12 to our condensed consolidatedfinancial statements for the three and six months ended June 30, 2006.

*Costs andExpenses*.

*Cost ofRevenues*. The cost of revenues consisted of product anddelivery costs relating to the initial deliveries of video phones was $739 and$1,181, respectively, for the three and six months ended June 30, 2006. Costsof revenues during the three and six months ended June 30, 2005 were $1,266 and$1,390, respectively.  Included in thesecosts for the three and six months ended June 30, 2006 were inventoryadjustments for obsolescence and lower market valuations of $466 that reducedinventory and increased cost of revenues, freight charges, product reworkexpenses, reserves for consumer rebates and other costs related to the productthat collectively totaled $91 and $51, respectively, for the three and sixmonths ended June 30, 2006.

*Engineeringand Development*. Engineering and development expenses primarily consist of compensation,and the cost of design, programming, testing, documentation and support of theCompany’s video phone product. Engineering and development costs were $1,540 for the three months endedJune 30, 2006, compared with $1,243 for the three months ended June 30,2005.  For the six months ended June 30,2006 and 2005, such costs were $2,994 and $2,462, respectively.  These increases of $297, or 24%, for thethree months ended June 30, 2006, and $532, or 22%, for the six months endedJune 30, 2006, reflects the Company’s increased concentration of itsengineering staff, and related costs, for the further and continuingdevelopment of its video phone product.

*Sales andMarketing*.  Sales andmarketing expenses consist primarily of compensation (which includescompensation to manufacturers representatives and distributors), attendance atconferences and trade shows, travel costs, advertising, promotions and othermarketing programs (which includes expenditures for co-op advertising and newmarket development) related to the continued introduction of the Company’svideo phone product.  Sales and marketingcosts were $548 for the three months ended June 30, 2006, compared with $640for the three months ended June 30, 2005. Sales and marketing costs were $1,201 for the six months ended June 30,2006, compared with $1,018 for the six months ended June 30, 2005. Thisdecrease of $92, or 14%, for the three months ended June 30, 2006 is primarilythe result of lower trade show expenditures. The increase of $183, or 18%, for the six months ended June 30, 2006,reflects the increased staff, advertising and related marketing and promotionalexpenditures associated with the Company’s video phone product.

*Generaland Administrative*. General and administrative expenses consist primarily of expendituresfor administration, office and facility operations, finance and generalmanagement activities, including legal, accounting and professional fees.  General and administrative expenses were$1,846 for the three months ended June 30, 2006, compared with $1,017 for thethree months ended June 30, 2005. These same expenses were $4,369 for the sixmonths ended June 30, 2006, compared with $1,951 for the six months ended June30, 2005. These increases of $829, or 82%, for the three months ended June 30,2006, and $2,418, or 124%, for the six months ended June 30, 2006, wereprimarily attributable to certain expenses incurred during the three and sixmonths ended June 30, 2006 that were not incurred during the three and sixmonths ended June 30, 2005. These expenses included non cash charges of $225and $416, respectively, for the three and six months ended June 30, 2006 from theCompany’s adoption of the fair value recognition provisions of Statement ofFinancial Accounting Standards (“SFAS”) No. 123 (Revised 2004), “Share-BasedPayment,” (“SFAS 123(R)”), using the modified-prospective-transitionmethod.  Prior to January 1, 2006, theCompany’s stock-based employee compensation plans were accounted for under therecognition and measurement provisions of Accounting Principles Board Opinion “APBNo. 25, and related Interpretations, as permitted by Financial AccountingStandards Board (“FASB”) Statement No. 123, “Accounting for Stock-BasedCompensation,” (“SFAS 123”). The Company did not recognize stock-based employeecompensation cost in its statement of operations for periods prior to January1, 2006 as all options granted had an exercise price equal to the market valueof the underlying common stock on the date of grant (for more details, refer toNote 6 to our condensed consolidated financial statements for the three and sixmonths ended June 30, 2006.) In addition, this increase reflects $345 and$1,150, respectively, for the three and six months ended June 30, 2006 ofaccrued penalties related to private placements in June 2004 and August 2005(for more details, refer to Note 3 to our condensed consolidated financialstatements for the three months ended June 30, 2006).  Furthermore, the increase for the three andsix months ended June 30, 2006, includes legal, accounting and auditing fees of$130 and $529, respectively, in excess of fees incurred in the same periods of2005.  These increased fees areassociated with its Sarbanes-Oxley internal control compliance implementationfor 2005 and restatements of prior filings with the Securities and ExchangeCommission.   In addition, rent expense increasedby $97 and $165, respectively, for the three and six months ended June 30, 2006over the same periods in 2005.

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Interest and OtherIncome and Interest Expense.  Interestand other income and interest expense consist of interest earned on cash andcash equivalents. Interest and other income decreased from $109 for the threemonths ended June 30, 2005 to $100 for the three months ended June 30, 2006 asa result of additional interest earned on higher interest rates in secondquarter of 2006 compared to the same period in 2005, offset by an insurancerefund of $36 received in June 2005. Interest earned increased from $175 for the six months ended June 30,2005 to $233 for the six months ended June 30, 2006, primarily due to higheraverage level of invested funds and interest rates during the six months of2006 compared to the same period in 2005. During the three and six months ended June 30, 2006, the Company earnedinterest on average cash balances of approximately $8,844 and $11,186,respectively. In comparison, during the three and six months ended June 30,2005 the Company earned interest on average cash balances of approximately$8,844 and $9,936, respectively.

Income Taxes.  TheCompany has incurred net operating losses since inception and accordingly hadno income taxes and has not recorded any income tax benefit for those losses,since realization of such benefit is currently uncertain.

Non Cash Change in Fair Value of Warrants and Conversion Options*.* For the three months endedJune 30, 2006 the non cash change in fair value of warrants and conversionoption was a loss of $520.  For the threemonths ended June 30, 2005 the non cash change in fair value of warrantsand conversion option was income of $2,466. For the six months ended June 30,2006 the non cash change in fair value of warrants and conversion option was aloss of $339.  For the six months endedJune 30, 2005 the non cash change in fair value of warrants and conversionoption was income of $7,642. These marked to market adjustments are primarily aresult of changes in our common stock price at each reporting period related toour June 24, 2004 private placement of our Series A Convertible Preferred Stockand Warrants.

Liquidity andCapital Resources.

          As of June 30, 2006, our primarysource of liquidity consisted of cash and cash equivalents that are highlyliquid, are of high quality investment grade and have original maturities ofless than three months.

          At June 30, 2006, we had cashand cash equivalents of $7,232 as compared to cash and equivalents of $16,277at December 31, 2005. Net cash used in operating activities was $3,210 and$8,808, respectively, for the three and six months ended June 30, 2006, ascompared to $2,714 and $5,922, respectively used for the same periods in 2005.The increase in net cash used in operating activities was primarilyattributable to our increase in expenditures during the three and six monthsended June 30, 2006 compared to the same periods in 2005, relatedprimarily to an increase in staffing of approximately $342 and $894,respectively, increased expenditures of approximately $487 and $1,019,respectively, paid to certain investors in penalties, a $480 expenditure duringthe first quarter of 2006 for repurchased products previously sold to GeneralInstrument totaling $1,064, which included the offset of $584 of accountsreceivables due the Company, and increased expenditures during the three andsix months ended June 30, 2006 for facility costs of approximately $97 and$165, respectively, over such expenditures in the same period in 2005.  No bad debt expense was recorded for thethree and six months ended June 30, 2006 and 2005.

           Cash used for investing activitieswere primarily a result of investments in equipment for product development andmanufacture as well as for general administrative purposes.   For the three month periods ending June 30,2006 and 2005, such investments were $59 and $242, respectively.  For the six month periods ending June 30,2006 and 2005, such investments were $250 and $322, respectively.

Cash provided byfinancing activities primarily through various private placements of ourCompany’s securities, through the exercise of warrants and through the exerciseof non-executive employees’ and prior employees’ stock options during the threemonths ended June 30, 2006, totaled $7 compared to $547 provided duringthe same period in 2005.   For the sixmonths ended June 30, 2006, cash provided by financing activities totaled$13 compared to $1,924 provided during the same period in 2005.

Operations and Liquidity.

             To date, we have funded operationsprimarily through multiple private sales of equity securities and through aninitial public offering of common stock in April 1999. As of June 30,2006 we have no outstanding debt and our assets are not pledged as collateral.However, the financing secured on August 11, 2006 (see Note 14 to ourcondensed consolidated financial statements for the three and six months endedJune 30, 2006), will add long term debt to the balance sheet. We continueto evaluate the possibilities to obtain further additional financing throughpublic or private equity or debt offerings, bank debt financing, assetsecuritizations, or from other sources. Such additional financing would besubject to the risk of availability, may be dilutive to our stockholders, orcould impose restrictions on operating activities. There can be no assurancethat this additional financing will be available on terms acceptable to us, ifat all.

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                The report of the independent registered publicaccounting firm for the year ended December 31, 2005 includes anexplanatory paragraph stating that our Company had suffered recurring lossesfrom operations and had an accumulated deficit of $229,092, and that theseissues raised substantial doubt about our Company’s ability to continue as agoing concern. Our short term cash requirements and obligations includeinventory, accounts payable and capital expenditures from continuingoperations, operating expenses, and the redemption of preferred stock, of which$166 is required to be redeemed in June 2007, although this redemption canbe made in common stock if certain conditions are met.   In addition, the August 2005 privateplacement includes cash payment penalties of 1.5% per month for the period thatthe shares in the transaction fail to be registered. . The RegistrationStatement covering the shares under this private placement was not declaredeffective until June 1, 2006.  Until suchtime as the shares were registered the Company was subject to the penaltyprovision under this private placement. For the three months ended June 30,2006 and 2005 the Company recorded and expensed related penalties of $599 and$0, respectively.  For the six monthsended June 30, 2006 and 2005 the Company recorded and expensed relatedpenalties of $1,387 and $0, respectively. The related unpaid penalties accruedas of June 30, 2006 and December 31, 2005 was $630 and $525, respectively.  On July 25, 2006, the Company amended the termsof the additional investment right that was granted to an investor as part ofthe August 2005 private placement, with respect to a portion of shares ofcommon stock purchasable thereunder and agreed to apply $158 of accruedpenalties towards the exercise price of such amended additional investmentright, for the purchase of 129,950 shares of common stock. The penalties hadaccrued with respect to the Company’s inability to register the shares acquiredby such investor in the private placement within 120 days of thetransaction.  In consideration for thisamendment and application of the exercise proceeds the investor agreed toforego any cash payment of the penalties other than as available through theproceeds of the exercise of the amended investment right and to grant to theCompany a release of all claims relating to the late registration of theprivate placement shares, other then the aforesaid penalties.  The amendedadditional investment right provides that the investor thereof may purchase the129,950 shares of common stock for a period of 760 days beginning June 1, 2006for an exercise price of $1.515 per share.  The terms of the additionalinvestment rights with respect to the remaining 1,424,050 shares of commonstock purchasable thereunder remain unchanged. On July 26, 2006 this investor exercised the additional investment rightfor 129,950 shares.  The ending ofthe General Instrument agreement on February 17, 2006 places additional cashburdens on the Company and this could impact our cash requirements andusage.  As part of ending its agreementwith General Instrument, and in anticipation of WorldGate inventoryrequirements as a result of taking full responsibility for productdistribution, WorldGate negotiated the right to buy back about two-thirds ofthe units sold to General Instrument, valued at approximately $2,765 (basedupon the original sales price to General Instrument), for approximately $1,064.This is less than half of what it would cost the Company to purchase the sameinventory from its manufacturing sources. For more details, refer to Note 12 to our condensed consolidatedfinancial statements for the three and six months ended June 30, 2006.

We believe, basedon our internal forecasts and assumptions including among others, assumptionsregarding our short term cash requirements, our projected revenue growth, andour ability to obtain stockholder approval and an effective registration forour recent August 11, 2006 funding transaction (see Note 14 to our condensedconsolidated financial statements for the three and six months ended June 30,2006), that we would have sufficient cash on hand to meet our obligations intothe second half of 2007.

Our ability to generate cash is dependent upon thesale of our Ojo product and on obtaining cash through capital markets.  We began generating revenue from commercialshipment of our Ojo product in April 2005 and we expect revenues to increase asthe product continues to roll out to the marketplace. Depending on the ramp upof sales and the achievable margins, the increased level of sales activityshould have a positive impact on our cash flows from operations, which willsupport our ability to meet our cash requirements in the long term. Given thatour video phone business involves the development of a new product line with nomarket penetration, in an underdeveloped market sector, no assurances can begiven that sufficient sales, if any, will materialize.

We, however,remain hopeful that sufficient sales will materialize and/or that sufficientfunding can be developed through ongoing operations or further additionalfinancings to continue our operations beyond 2007.

Our long term cashrequirement obligations are primarily comprised of the items noted above. Wehave no long term debt as of June 30, 2006. However, the financing secured on August 11, 2006 (see Note 14 to ourcondensed consolidated financial statements for the three and six months endedJune 30, 2006), will add long term debt to the balance sheet.  We havelimited capacity to reduce our workforce and scale back on capital andoperational expenditures to decrease our cash usage.

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ITEM 3.   QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT MARKET RISK.

Interest RateRisk.  Our exposure to market riskrelated to changes in interest rates relates primarily to our investment portfolio.  We invest in instruments that meet highcredit quality standards, and we limit the amount of credit exposure withrespect to any one issue, issuer and type of investment.

As of June 30,2006, the Company’s cash and cash equivalents were $7,232, which were comprisedof securities having a maturity of less than three months.  Due to the average maturity and conservativenature of our investment portfolio, management believes a sudden change ininterest rates would not have a material effect on the value of the portfolio.Manage­ment estimates that had the average yield of our investments decreasedby 100 basis points, our interest income for the three months ended June 30,2006 would have decreased by approximately $69. This estimate assumes that the decreaseoccurred on the first day of 2006 and reduced the yield of each investmentinstrument by 100 basis points.  Theimpact on our future interest income of future changes in investment yieldswill depend largely on our total investments.

Foreign CurrencyExchange Risk.  Although we transactbusiness in various foreign countries substantially all of our revenues andcosts to date have been denominated in U.S. dollars.  Although our agreement with Mototech, Inc.(not an affiliate of General Instruments or Motorola), our contractmanufacturer in Taiwan, is denominated in U.S. dollars, their materialacquisition costs are subject to exchange rate changes that could impact ourproduct costs.

# ITEM 4.    CONTROLS AND PROCEDURES.

      Disclosure Controls and Procedures. Wemaintain disclosure controls and procedures (as defined in Exchange Act Rule13a-15(e) and 15d-15(e)) that are designed to ensure that information requiredto be disclosed in reports that we file or submit under the Securities ExchangeAct of 1934 is recorded, processed, summarized, and reported within the timeperiods specified in the Securities and Exchange Commission’s rules and forms,and that such information is accumulated and communicated to our management,including our Chief Executive Officer and Chief Financial Officer, asappropriate to allow timely decisions regarding the required disclosures. Indesigning and evaluating the disclosure controls and procedures, we recognizethat any controls and procedures, no matter how well designed and operated, canprovide only reasonable assurance of achieving the desired control objectives.

We carried out an evaluation, under the supervisionand with the participation of management, including our Chief Executive Officerand Chief Financial Officer, of the effectiveness of the design and operationof our disclosure controls and procedures as of June 30, 2006.  Our Chief Executive Officer and ChiefFinancial Officer determined that we have a material weakness (as defined underthe standards established by the Public Company Accounting Oversight Board)that exists with respect to our control procedure for the accounting andreporting of complex financial transactions.

       As previously reported in our Form 10-Kfor the year ended December 31, 2005, we identified material weaknesses in ourcontrol procedure for the accounting and reporting of complex financialtransactions. These material weaknesses contributed to restatements of ourfinancial statements in our annual and quarterly reports from the quarter endedMarch 31, 2004 through September 30, 2005.

       To address this material weakness, wehave engaged outside experts to provide counsel and guidance in areas where wecannot economically maintain the required expertise internally (e.g., with theappropriate classifications and treatments of complex and non-routinetransactions.)

       As a result of the material weaknessidentified with respect to our control procedures for the accounting andreporting of complex transactions, the Chief Executive Officer and ChiefFinancial Officer concluded that our disclosure controls and procedures are notdesigned and are not effective in ensuring that the information required to bedisclosed by our Company in the reports that we file and submit under the ExchangeAct is recorded, processed, summarized and reported within the time periodsspecified in the Commission’s rules and forms.  Except as identifiedabove, there have been no changes in our internal control over financialreporting that occurred during the quarter ended June 30, 2006, that havematerially affected, or are reasonably likely to materially affect, ourinternal control over financial reporting.

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**PART II.OTHER INFORMATION**

# ITEM 1.   LEGALPROCEEDINGS.

None.

# ITEM 1A  RISKFACTORS.

There are nomaterial changes from the risk factors previously disclosed in our annualreport on Form 10-K for the fiscal year ended December 31, 2005 in response toItem 1A of Form 10-K.

# ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.

# None.

# ITEM 3. DEFAULTS UPON SENIOR SECURITIES.

None.

# ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.

None.

# ITEM 5.  OTHERINFORMATION.

None.

ITEM 6.  EXHIBITS.

The following is alist of exhibits filed as part of this report on Form 10-Q.  Where so indicated by footnote, exhibits thatwere previously filed are incorporated by reference.  For exhibits incorporated by reference, thelocation of the exhibit in the previous filing is indicated parentheticallyexcept in those situations where the exhibit number was the same as set forthbelow.
| Exhibit | ** ** | **Description**                                                                                                                                                             |
|---------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1     |       | Amended and Restated Certificate of Incorporation  (3)                                                                                                                      |
| 3.2     |       | Amended and Restated Bylaws (1)                                                                                                                                             |
| 3.3     |       | Certificate of Amendment to Certificate of  Incorporation, dated October 18, 2004 (3)                                                                                       |
| 3.4     |       | Certificate of Designations, Preferences and Rights  of the Series A Convertible Preferred Stock of the Company dated June 23,  2004 (2)                                    |
| 4.1     |       | Securities Purchase Agreement, dated as of August  11, 2006, by and among the Company and Cornell Capital Partners, LP*                                                     |
| 4.2     |       | Investor Registration Rights Agreement, dated August  11, 2006, by and among the Company and Cornell Capital Partners, LP*                                                  |
| 4.3     |       | Form of Secured Convertible Debenture issuable by  the Company to Cornell Capital Partners, LP pursuant to the Securities  Purchase Agreement, dated as of August 11, 2006* |
| 31.1    |       | Certification of Chief Executive Officer Pursuant to  Rule 13a-14(a)*                                                                                                       |
| 31.2    |       | Certification of Chief Financial Officer Pursuant to  Rule 13a-14(a)*                                                                                                       |
| 32.1    |       | Certification of Chief Executive Officer Pursuant to  18 U.S.C. Section 1350, as adopted by Section 906 of the Sarbanes-Oxley Act  of 2002*                                 |
| 32.2    |       | Certification of Chief Financial Officer Pursuant to  18 U.S.C. Section 1350, as adopted by Section 906 of the Sarbanes-Oxley Act  of 2002*                                 |

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* Filed herewith

(1) Incorporated by reference to the exhibits to our Form 10-QReport for the quarter ended March 31, 1999.

(2) Incorporated by reference to the exhibits to our Form 8-K CurrentReport filed on June 25, 2004 (Exhibit 3.1).

(3) Incorporated byreference to the exhibits to our Form 10-Q Report for the quarter endedSeptember 30, 2004 as filed on November 17, 2004.

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**SIGNATURES**

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.
|        |            | WORLDGATE COMMUNICATIONS, INC.               |
|--------|-----------------|----------------------------------------------|
|   |            |                                         |
|   |            |                                         |
|   |            |                                         |
| Date:  | August 14, 2006 | /s/ Hal M. Krisbergh                         |
|   |            | Hal M. Krisbergh                             |
|   |            | Chairman and Chief Executive Officer         |
|   |            | (Principal Executive Officer)                |
|   |            |                                         |
|   |            |                                         |
| Date:  | August 14, 2006 | /s/ Joel Boyarski                            |
|   |            | Joel Boyarski                                |
|   |            | Vice President and Chief Financial Officer   |
|   |            | (Principal Financial and Accounting Officer) |

 

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